Dollarization and Financial Integration

40 Pages Posted: 16 May 2008

See all articles by Cristina Arellano

Cristina Arellano

University of Minnesota - Twin Cities - Department of Economics

Jonathan Heathcote

Minneapolis Fed

Multiple version iconThere are 2 versions of this paper

Date Written: February 2007

Abstract

How does a country's choice of exchange rate regime impact its ability to borrow from abroad? We build a small open economy model in which the government can potentially respond to shocks via domestic monetary policy and by international borrowing. We assume that debt repayment must be incentive compatible when the default punishment is equivalent to permanent exclusion from debt markets. We compare a floating regime to full dollarization. We find that dollarization is potentially beneficial, even though it means the loss of the monetary instrument, precisely because this loss can strengthen incentives to maintain access to debt markets. Given stronger repayment incentives, more borrowing can be supported, and thus dollarization can increase international financial integration. This prediction of theory is consistent with the experiences of El Salvador and Ecuador, which recently dollarized, as well as with that of highly-indebted countries like Italy which adopted the Euro as part of Economic and Monetary Union: in each case, around the time of regime change, spreads on foreign currency government debt declined substantially.

Keywords: Dollarization, sovereign debt

JEL Classification: F33, F34, F36

Suggested Citation

Arellano, Cristina and Heathcote, Jonathan, Dollarization and Financial Integration (February 2007). CEPR Discussion Paper No. DP6116, Available at SSRN: https://ssrn.com/abstract=1133741

Cristina Arellano (Contact Author)

University of Minnesota - Twin Cities - Department of Economics ( email )

271 19th Avenue South
Minneapolis, MN 55455
United States
612-6250511 (Phone)

HOME PAGE: http://www.econ.umn.edu/~arellano/

Jonathan Heathcote

Minneapolis Fed ( email )

90 Hennepin Avenue
Minneapolis, MN 55480
United States

HOME PAGE: http://www.jonathanheathcote.com

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