Dollarization and Financial Integration

Cristina Arellano, University of Minnesota
Jonathan H. Heathcote, Federal Reserve Bank of Minneapolis

Abstract

How does a country’s choice of exchange rate regime impact its ability to borrow from abroad? We build a small open economy model in which the government responds to shocks by adjusting domestic monetary policy and foreign borrowing. Sovereign borrowing is subject to endogenous limits, which are just tight enough to ensure repayment when the default punishment is equivalent to permanent exclusion from debt markets. In this environment, dollarizing implies renouncing monetary policy as an instrument for stabilization. This loss of the monetary instrument can make access to international debt markets more valuable, thereby increasing the amount of borrowing that can be supported in equilibrium. This mechanism linking dollarization to financial integration is consistent with the observed declines in spreads on foreign-currency debt for a set of countries that recently adopted the dollar or the euro.