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Title:How strong is the case for dollarization in Central America? An empirical analysis of business cycles, credit market imperfections and the exchange rate PDF Logo
Authors:Lindenberg, Nannette
Westermann, Frank
Issue Date:2010
Series/Report no.:Working Paper, Institute of Empirical Economic Research, University of Osnabrück 83
Abstract:In this paper, we contrast two different views in the debate on official dollarization. The Mundell (1961) framework of optimal currency areas and a model on boom-bust cycles, by Schneider and Tornell (2004), who take account of credit market imperfections prevalent in middle income countries. We highlight that the role of the exchange rate is strikingly different in the two models. While in the Mundell framework the exchange rate is expected to smooth the business cycle, the other model predicts that the exchange rate plays an amplifying role. We empirically evaluate both models for eight highly dollarized Central American economies, and find that the main benefit of official dollarization derives from avoiding a mismatch between foreign currency liabilities and domestic revenues, as well as the boom-bust episodes that are likely to follow from it. Using a new method of Cubadda (1999, 2007), we furthermore test for cyclical comovement and reject the hypothesis that the countries form an optimal currency area with the United States according to the Mundell definition.
Subjects:dollarization
real exchange rate
business cycle comovement
serial correlation common feature
boom-bust cycles
credit market imperfections
Central America
JEL:E32
E52
F36
O54
Document Type:Working Paper
Appears in Collections:Working Papers, Institut für Empirische Wirtschaftsforschung, Universität Osnabrück

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