Dollarization Dynamics

Abstract

This study explores the consequences of dollarizing an economy with an initial dollar shortage. We show that the resulting transitional dynamics are tantamount to that of a “sudden stop”: consumption of tradable goods fall, the real exchange rate depreciates abruptly by a discrete drop in domestic prices and wages followed by a gradual appreciation from positive inflation. With nominal rigidities the economy first falls into a recession. This is true even if all prices and wages are allowed to adjust flexibly on impact. The subsequent recovery in activity always “overshoots” the steady state: the non-tradable sector transitions from the initial recession to a boom, then asymptotes to its steady state.