Dollarization as a Signaling Device

The objective of this paper is to point out that dollarization, apart from being a commitment device, may also be used as a signaling device if there is uncertainty about the government’s intentions. To this end, we modify the standard approach to modeling monetary policy by introducing two types of government: good and bad. It is assumed that the good government conducts optimal policy while the bad government prefers to finance higher (than optimal) government expenditure by printing money. People do not observe the type of government, however they know the probability distribution over the two government types. Due to this uncertainty, the good government cannot achieve the first best even if it conducts optimal monetary policy. Hence, the good government has an incentive to dollarize, while the bad governments avoids this step. As a result, we obtain a separating equilibrium where dollarization is a perfect signal of the government type.