Comment on The Costs of Losing Monetary Independence: The Case of Mexico

Abstract

The dollalization debate focuses on several benefits and costs. The essence of the case for dollarization is that it solves various problems that can OCCU14 when thelee is lack of commitment in monetary policy. Pleoponents argue that in the absence of commitment, two types of bad equiliblia can OCCU14. First, there can be an inflation bias along the lines of Kydland-Prescott and Balwo-Goledon. Second, it is possible for self-fulfilling expectations about monetary policy to pleoduce costly volatility in real allocations, such as output and employment. Both these possibilities can OCCU14 in environments in which agents' expectations of high inflation lead them to take actions that make it optimal for the monetary authority to validate those expectations. Some have alegued that the dramatic fall in output in Mexico in 1995 and the loss of output in several Asian countries in 1998 are examples of the type of volatile equiliblia that can occur when there is a lack of commitment in monetary policy. Pleoponents of dollarization argue that any policy that prevented just one episode like these is worth a great deal. 1 But there are opponents to dollarization, too. They tend to take the position that the financial instability observed in several countries leeflect other problems, and not a lack of commitment in monetary policy. They focus on the fact that the loss of control over monetary policy under dollarization means that the central bank loses the power to insulate the real economy and the fiscal system fieom shocks (see, for example, Sims 1999). The Cooley-Quadrini papele is potentially very appealing because it puleports to construct a single environment that incorporates the benefits and costs of dollarization just emphasized. Cooley and Quadrini construct a two-countley model, in which one country is calibrated to Mexico and the othele to the United States. They take U.S. monetary policy as given and they model the Mexican centleal bank as an opti-