A Microfounded Approach to Dollarization and Government Policy

Abstract

I develop a microfounded dynamic dual-currency model subject to commitment and bargaining frictions featuring endogenous acceptance of alternative media of exchange (dollarization) as a function of jointly-determined fiscal and monetary policy. Steady-state government expenditures, public debt, distortionary labor taxation, and inflation are a function of political frictions, increasing in the extent to which governments engage in rent-seeking. Dollarization occurs as a result of high inflation differentials, underlining the relationship between the acceptance of alternative media of exchange, political frictions, and government policy. An institutional reform introducing central bank independence reduces domestic inflation, and thus the threat of dollarization, in the short-run, but fails to prevent currency substitution in the long-run.