The Economics of Exchange Rates and the Dollarization Debate : The Case Against Extremes

Abstract

The 1990s was a decade of global boom and bust, and exchange rates emerged as a key economic variable. In the early part of the decade, developing countries were encouraged to adopt fixed exchange rates that were seen as providing a nominal anchor to the domestic price level that could enforce monetary policy discipline and ensure low inflation. With most economists maintaining that the equilibrium level of economic activity is neutral with regard to systematic monetary and exchange-rate policy, countries were viewed as giving up little by adopting nominal anchor policies restricting monetary policy and tying down the exchange rate. Many East Asian economies fixed their exchange rates at undervalued real parities, thereby fostering exports and contributing to the Asian growth miracle. In Latin America, Brazil adopted a fixed exchange rate as part of a nominal anchor strategy combating high inflation. Argentina, with its historically poor inflation performance, went the furthest down the fixed exchange-rate path by adopting a dollar-based currency board. This involved pegging the peso to the dollar and tying the supply of monetary base to dollar reserves. The adoption of these policies coincided with faster economic growth and significantly reduced inflation, particularly in Brazil and Argentina. However, this good performance crumbled in the latter part of the de-

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