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Vita

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Darryl McLeod

Currency substitution or “dollarization” is often viewed as an inflationary source of exchange rate volatility. But in fact the consequences of “partial dollarization” depend on how Central Banks respond to competition. If seigniorage financed fiscal deficits are fixed, dollarization can lead to exchange rate fluctuations and higher inflation if not new capital controls, as much of the currency substitution literature suggests. However, if Central Banks respond by lowering money growth to maximize seigniorage revenues, inflation falls. This paper presents a simple model of currency competition and with open capital markets and optimizing central banks to illustrate this point. Empirical tests for Latin America and twenty other countries suggest that dollarization is both a legacy of past inflation and a constraint on future inflation. Dollarization may complicate monetary policy and prudential regulation, but currency competition also appears to accelerate disinflation and contribute to inflation convergence, particularly in Latin America.

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Capsule Story Cras enim. Vestibulum ante ipsum primis in faucibus orci luctus et ultrices posuere cubilia Curae; Ut eu augue. Integer risus wisi, semper eu, congue quis, lobortis ut, massa. Vestibulum auctor vestibulum lectus. Vivamus neque. Cras lobortis. Aenean ut turpis eu libero volutpat euismod. Donec eget lectus vitae ligula ornare tempor. Vivamus scelerisque lorem a elit. Sed id mauris.

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