Exploring the Implications of Official Dollarization on Macroeconomic Volatility

It has been argued that (official) dollarization facilitates financial integration and a better performance of the domestic banking system. However, before adopting dollarization it is necessary a deep discussion on the pros and cons of this scheme. With a few exceptions, the advantages of dollarization have not been discussed in a dynamic general equilibrium framework, especially for partially dollarized economies such as Peru, Argentina, Bolivia, that are supposed to be good candidates to follow this kind of regime. After reviewing the arguments for and against dollarization, this paper explores its implications on the volatility of the main macroeconomic variables of an emerging small open economy that faces terms-of-trade shocks. I use dynamic equilibrium models as a laboratory to study these issues and contrast two environments: a partially dollarized economy with flexible exchange rate (calibrated for the Peruvian economy) and a fully dollarized economy. Simulation exercises are performed to analyze in both cases the volatility of key variables such as output, inflation rate, consumption and investment, among others. I find that full dollarization implies (1) higher real volatility but that it is not significantly different from the volatility generated in a flexible exchange rate; (2) lower inflation level and volatility; (3) slightly higher or similar fiscal deficit volatility; and (4) higher output response to terms-oftrade shocks.