Dollarization, Exchange Rate Regimes and Government Quality

The dollarization of the domestic banking system represents a source of vulnerability for emerging market countries, and a debate has emerged over whether the exchange rate regime has an impact on the degree of dollarization. This paper argues that the regime is far less important than the literature has previously claimed. Unofficial dollarization results from a lack of faith in the domestic currency, which ultimately stems from the belief that the government will not follow policies that promote long-run currency stability. Empirical results indicate that improved government quality reduces unofficial dollarization, while the exchange rate regime plays no direct role in promoting dollarization. These results confirm the intuition that there is no easy fix that restores confidence in the domestic currency. They also provide a potential explanation for the steady progression of unofficial dollarization throughout the 1990’s in spite of falling inflation rates. JEL Classification: F33, G21. Keyword(s): Unofficial dollarization, exchange rate regimes, government quality. _____________ * Correspondence: Adam Honig, Department of Economics, 315 Converse Hall, Amherst College. Amherst, MA 01002-5000. Email, [email protected]. Phone: (413) 542-5032. Fax: (413) 542-2090.