ECON3315 International Economic Issues

1. ECON3315International Economic Issues Instructor: Patrick M. Crowley Issue 16: Dollarization and Currency Boards

2. Overview • Dollarization vs euroization • Costs and benefits of giving up the monetary unit • Optimum currency area theory • OCA in practice • Currency boards • The politics of exchange rates

3. Dollarization vs euroization Defn: monetary authority = who issues the monetary base Defn: monetary base = currency and reserves (what is used for making payments) Defn: monetary standard = value of whatever is used as the medium of exchange and unit of account Defn: convertibility = ability to convert monetary base into another currency Dollarization is where a country replaces its own monetary base with the US dollar – therefore no monetary authority required. Same idea works with euroization, although most countries adopting the euro are already in the European Union.

4. Costs and benefits of dollar/euroization • Costs of dollarizing: - giving up control over exchange rate (and difficult to reverse) - loss of seigniorage - asymmetric shocks • Benefits of dollarizing: - monetary policy credibility and economic stability - increased trade - no capital controls required

5. Optimum currency area theory OCA came from famous paper by Robert Mundell (Canadian) in 1963 Main idea was that if countries had similar business cycles then single currency appropriate If business cycles not that similar, still possible as long as i) labor mobility, and/or ii) capital mobility and/or iii) fiscal redistribution (“coinsurance” or “equalization payments”) Mundell looked to existing federations and noted that most of them had one or more of the above

6. Benefits of joining a MU

7. Costs of joining a MU

8. Costs vs benefits

9. OCAs in practice • Dollarized zones differ from monetary unions as in case of euro area all countries have a say in euro area monetary policy, whereas dollarized/euroized countries do not. • In practice monetary policy has to be suitable for business cycles or there has to be i) high level of trade or ii) high level of labor mobility • Easy to show theory but very difficult to implement OCA theory in practice

10. Currency boards • Currency board idea is to get all gains from using another country’s currency, without risk of devaluation and keeping option to reverse to legacy currency • Limited success in practice if government not already credible • Problems can arise from issuance of currency by other levels of government (e.g. Argentina)

11. Politics of exchange rates • Exchange rate is important economic policy lever the more open economy is • For most developing/transition countries a political trade off between policy autonomy (more flexible exchange rates) and attracting more policy credibility • Most countries resort to dollarization or currency boards after a bout of severe inflation or loss of confidence in government policies for other reasons