The Benefits of Dollarization When Stabilization Policy Lacks Credibility and Financial Markets Are Imperfect

Abstract

Dollarization entails two potentially large benefits for emerging economies. First, it may eliminate price and wealth distortions induced by the lack of credibility of stabilization policies. Second, it may improve the efficiency of financial markets by weakening informational or institutional frictions driving credit constraints. Quantitative analysis of a dynamic, stochastic equilibrium model calibrated to Mexican data shows that the mean welfare gains of eliminating policy uncertainty are staggering, ranging between 6.4 and 9 percent of trend consumption. The mean welfare gain of weakening credit constraints is 4.6 percent. Liability dollarization and sharp fluctuations in relative prices play a key role in these results.

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