An open economy model with currency substitution and real dollarization

Abstract

PurposeThe paper aims at developing a theoretical model for de facto dollarized small open economies focusing on currency substitution and nominal wages indexation to the exchange rate.Design/methodology/approachThe analysis is performed in a general equilibrium “New Open Economy Macroeconomics” framework with nominal rigidities and imperfect competition in the nontraded good sector.FindingsThe paper finds that a dollar‐indexed economy with low degrees of payments/financial dollarization could experience higher costs in terms of exchange rate and output fluctuations when nominal shocks dominate real shocks, making stabilization programs more difficult to achieve in a rapid and less costly way.Practical implicationsThe speed of adjustment of macro variables is faster in the highly dollarized economy as a response to a higher and more volatile inflation rate. A higher level of financial dollarization increases the frequency of domestic prices and wages revisions to nominal exchange rate shocks. This might explain, in turn, why nominal disturbances are shorter lived in the higher dollarized economies, and the asymmetry between financial and real dollarizationOriginality/valueContrary to the “conventional wisdom” that predicts a positive relationship between the degrees of dollarization and the exchange rate pass‐through, our model shows that the degree of dollarization and the degree of dollar indexation are not necessarily the same or even correlated.