Why dollarization didn’t succeed: Comparing credibility and the impact of real shocks on small open economies

Abstract

This paper compares credibility and the impact of real shocks on a small open economy operating under two opposite corner solutions: a flexible exchange rate and official dollarization. Using an asymmetric two-country model, we show that although dollarization is an effective device to achieve price stability and avoid credibility problems, small open economies might be better off under a flexible regime than under dollarization following any symmetric or asymmetric shock. We also show that even when a small economy follows “fear of floating” practices, the costs of stabilization are smaller than those under dollarization. We interpret these results as consistent with the demise of the dollarization debate.