Assessing the Impact of Real Shocks on Small Dollarized Economies

This paper compares the impact of real shocks on small open economies operating under two opposite corner solutions: flexible exchange rates and official dollarization. Using an asymmetric two-country model of policy coordination, we show that although a pegged regime like dollarization is an effective device to achieve price stability, small open economies might be better off under a flexible exchange rate regime than under dollarization following any symmetric or asymmetric real shock. We also consider the claim that many small economies have only a limited ability to use their own monetary policy effectively and contrast the dollarization regime with one in which a small open economy follows "fear of floating" practices. In this case, we observe that unless its size is trivial, maintaining monetary policy sovereignty--even if it is not fully exploited--allows the domestic economy to experience lower losses from stabilization in the face of symmetric shocks. Only when an economy is negligibly small, are the costs of stabilization following "fear of floating" practices the same as those under dollarization.