Financial Dollarization and Central Bank Credibility

32 Pages Posted: 20 Apr 2016

See all articles by Kevin Cowan

Kevin Cowan

Adolfo Ibanez University

Quy-Toan Do

World Bank - Development Research Group (DECRG)

Date Written: June 12, 2003

Abstract

Why do firms and banks hold foreign currency denominated liabilities? Cowan and Do argue that foreign currency debt, by altering the effect of a devaluation on output, has a disciplining effect when the Central Bank's objectives differ from the social optimum. However, under imperfect information, bad priors about the Central Bank induce excess dollarization of liabilities, which in turn limits the ability of the Central Bank to conduct an optimal monetary policy. In addition, the economy may become stuck in a "dollarization trap" in which dollarized liabilities limit the ability of agents to learn the true type of the monetary authority. The model has clear-cut policy implications regarding the taxation of foreign currency liabilities as a way to encourage perfect information and avoid dollarization traps. Moreover, it reinforces the existing argument for Central Bank independence. Finally, the authors believe this model to be consistent with a growing empirical literature on the determinants of foreign currency liabilities and their relationships to Central Bank credibility.

This paper - a product of the Poverty Team, Development Research Group - is part of a larger effort in the group to understand the determinants of financial fragility.

Suggested Citation

Cowan, Kevin and Do, Quy Toan, Financial Dollarization and Central Bank Credibility (June 12, 2003). World Bank Policy Research Working Paper No. 3082. Available at SSRN: https://ssrn.com/abstract=636444

Kevin Cowan (Contact Author)

Adolfo Ibanez University ( email )

Santiago
Chile

Quy Toan Do

World Bank - Development Research Group (DECRG) ( email )

1818 H. Street, N.W.
MSN3-311
Washington, DC 20433
United States

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