Dollarization Traps

Abstract

The paper analyzes dollarization in the sense of asset substitution, where a foreign currency competes with local assets, especially domestic capital, as a store of value, the impact of dollarization on capital accumulation and output, and why economies remain dollarized long after a successful inflation stabilization. We relate this dollarization hysteresis to a financial intermediation failure that happens during high inflation. We show that in dollarized countries, inflation stabilization policies may not have any effect on domestic capital accumulation, thus, preventing such policies for stimulating growth - i.e., dollarized economies are vulnerable to dollarization traps.

Keywords: Dollarization, Asset Substitution, Hysteresis, Inflation, Financial Intermediation

JEL Classification: E40, E50, F41, E41