Dollarization and Financial Integration

This paper builds a simple theoretical model designed to study dollarization. Each period, a benevolent government decides whether or not to dollarize, how much to borrow or lend on an international bond market, and, if dollarization has not occurred, the devaluation rate. In equilibrium, international borrowing is limited endogenously such that the government always chooses to repay when the penalty for default is permanent future exclusion from financial markets. Dollarization implies the loss of the devaluation rate as a policy instrument, but may still be optimal. The reason is that floating defaulters can use the devaluation rate as a substitute for debt in responding to country-specific shocks while dollarized economies in default find themselves in a more uncomfortable situation. Thus dollarization reduces a government's incentives to default, and thereby increases a country's ability to borrow in equilibrium