Working Paper: CEPR ID: DP6116
Authors: Cristina Arellano; Jonathan Heathcote
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 Codes: F33; F34; F36
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| dollarization (F31) | credibility of sovereign borrowers (F34) |
| credibility of sovereign borrowers (F34) | international financial integration (F30) |
| dollarization (F31) | international financial integration (F30) |
| dollarization (F31) | borrowing capacity (H74) |
| dollarization (F31) | looser borrowing constraints (F65) |
| dollarization (F31) | less frequent debt crises (F34) |
| floating exchange rate regime (F33) | borrowing constraints (F34) |
| dollarization (F31) | welfare improvement (I38) |
| size of shocks to preferences and output (D11) | borrowing supported (F34) |