| Abstract: |
We study unofficial dollarization, i.e., the use of foreign money alongside
the domestic currency, in an environment where spatial separation and limited
communication create a role for currency and banks arise endogenously to
provide insurance against liquidity preference shocks. Unofficial
dollarization has been a common phenomenon in emerging market economies during
high inflations. However, successful disinflations have not necessarily been
followed by dedollarization. In particular, Argentina, Bolivia, Peru, Russia,
and Ukraine remained highly dollarized long after the inflation rate was
reduced to single digits. We refer to this phenomenon as a "dollarization
hysteresis paradox." It has also been observed in these economies that higher
inflation has a negative impact on output and financial intermediation, that
dollarization and capital flight adversely affect capital accumulation, and
that post-stabilization output growth is impeded by dollarization. This paper
presents an overlapping-generations model with random relocation of agents
between two locations that explains the dollarization hysteresis paradox and
several other stylized facts. The key link between inflation, dollarization,
and capital accumulation in the model is that high inflation undermines
financial intermediation, which leads to the adoption of a less efficient
production technology. As a result, it is possible for economies to become
stuck in low output "development traps," where the marginal product of capital
is the same as the return from holding dollars. In such an environment, we
show how dollarization can preclude further capital accumulation, even in the
presence of successful inflation stabilization policies. We complement
previous work on dollarization by allowing the "hard" currency to compete with
domestic capital as a store of value instead of focusing on either currency
substitution (where the use of a "hard" currency replaces the domestic
currency as a medium of exchange) or official dollarization (where the
domestic currency is abandoned altogether and replaced with the US dollar). We
assume that in the first period of life, agents inelastically supply labor and
receive the competitive market wage. A given fraction of agents will be
relocated to another location, and they can take only domestic currency with
them. Competitive banks arise endogenously in this environment to insure
against liquidity (relocation) shock. They issue demand deposits and hold
portfolios of domestic currency and the capital market assets, which may
include productive capital and dollars. There are two different productive
technologies that banks can invest in. The first one is a primitive autarkic
technology that they can use directly. The second one is an advanced
technology that requires the use of a financial center. The financial center
is a profit-maximizing natural monopoly. Its profit depends positively on the
scale of intermediation and production. Our model predicts that an increase in
inflation will reduce the capital stock, output and the scale of
intermediation. If inflation is low enough, the financial center makes a
positive profit, and the advanced technology is used. However, when inflation
exceeds a certain threshold, the profit of the center falls below zero, and it
shuts down. Hence competitive banks switch to the inefficient autarkic
technology. Even though the capital stock falls, the marginal product of
capital falls as well due to the switch in technology. This creates the
possibility of a "dollarization trap," in which dollars are held as a store of
value alongside the autarkic productive capital. The arbitrage condition
between the return on dollars and the marginal product of capital determines
the capital stock and output. A subsequent disinflation does not affect this
arbitrage condition, and thus has no effect on capital accumulation.
Therefore, as long as the economy gets stuck in the dollarization trap during
a high inflation episode, a successful stabilization of inflation is followed
neither by dedollarization nor by output recovery. |