Working papers // The Levy Economics Institute 344
When economies dollarize, their exchange rate and monetary policy, both considered to be sources of instability, are simultaneously discarded. Often, dollarization becomes an attractive option for developing countries that have experienced successive failures of exchange rate and monetary management. This paper makes use of a theoretical model that shows, contrary to the commonly accepted view, that a dollarized economy would experience financial instability in the event of external shocks should it attempt to operate discretionary fiscal policies. Shocks not simultaneously contained by adjustments to spending would lead to ever-increasing fiscal and current account deficits because public sector borrowing requirements can only be financed by selling bonds in the open market at constantly rising rates of interest. Hence, such a path cannot be an option. Alternatively, if fiscal spending were curbed at par with the shock, external and current account balances would converge to equilibrium, but trigger a recession and increased unemployment. Since this, too, is unacceptable, dollarization turns out to be a dead end.