Effect of Official Dollarization on a Small Open Economy: Ecuador

Abstract

This paper investigates the effects of dollarization on the macroeconomic performance of a small open economy, Ecuador, using a time series perspective. More specifically, we investigate how dollarization effects inflation, GDP, inflation uncertainty and money-price relationship in Ecuador. There are four main findings of this study. First, inflation is lower after dollarization. Second, GDP growth is higher after dollarization when several other factors like rising oil prices and increase in the equity markets of emerging economies are controlled. Third, inflation uncertainty measured by inflation variance through GARCH is lower during dollarization. Finally, money supply is endogenous after dollarization and exogenous before dollarization. A new test is proposed and implemented to investigate endogeneity of money. As a result, we conclude that dollarization improved the macroeconomic performance of Ecuador and changed the money-price relationship in Ecuador. The results are robust to different arguments about the empirical methodology.

Keywords: Dollarization, Ecuador, inflation uncertainty, GARCH model, money-price relation, endogeneity