Exploring the Implications of Official Dollarization on Macroeconomic Volatility

With a few exceptions, the advantages of dollarization have not been discussed in a dynamic general equilibrium framework, especially for partially dollarized economies that are supposed to be good candidates to follow this kind of regime. After reviewing the arguments for and against dollarization, this paper explores its implications on the volatility of the main macroeconomic variables of an emerging small open economy that faces terms-of-trade shocks. Dynamic equilibrium models are used as laboratories to study these issues and contrast two environments: a partially dollarized economy with flexible exchange rate (calibrated for the Peruvian economy) and a fully dollarized economy. Simulation exercises are performed to analyze in both cases the volatility of key variables such as output, consumption, investment, inflation rate, and fiscal deficit. The conclusions are that full dollarization implies (1) higher real volatility, especially on output and investment; (2) lower inflation volatility; (3) higher fiscal deficit volatility; (4) higher output response to terms-of-trade shocks. Consequently, in this context it is difficult to affirm that dollarization reduces country risk. Finally, the paper points up the role of price stickiness and countercyclical monetary policy in these findings.