Dollarization, Financial Intermediation and Real Activity: The Inflation Threshold

Abstract:     
This paper analyzes the relationship among inflation, dollarization, financial intermediation, and real activity. Empirical evidence suggests non-linearity in the effects of inflation on financial intermediation and real activity, i.e., the existence of an inflation threshold. Evidence also suggests that one way in which inflation affects financial intermediation in high inflation economies is through the substitution of dollars "under the mattress" for savings in domestic banks. Our model captures these empirical regularities. Inflation and real activity are positively related at low levels of inflation. When the inflation rate exceeds certain threshold, however, agents substitute in their portfolios dollars (a non-productive asset of constant value that also provides liquidity services) for deposits issued by domestic banks. This substitution reduces the scale of financial intermediation and the capital investment in the economy. As a consequence, at high levels of inflation the levels of capital stock and output become negatively related to the inflation rate.

Number of Pages in PDF File: 23

Keywords: Dollarization, Inflation, Financial Intermediation

JEL Classification: E40, E50, F41

working papers series