Capital markets and the exchange rate with special reference to the dollarization debate in Latin America

The paper reviews the main challenges faced by policymakers in emerging mar ket economies, EMs, in light of recent financial crises, and taking into ac count salient factors like the existence of partial dollarization, imperfec t credibility, weak financial systems, and contagion. The standard theory o f optimal currency areas is discussed and criticized for omitting the above factors. When these factors are taken into account, an extreme foreign exc hange regime like dollarization is shown to become much more attractive. Th e paper discusses the pros and cons of dollarization and, among other thing s, shows that the lack of a lender of last resort is not necessarily a majo r drawback in EMs. The paper also discusses inflation targeting, IT. In a f ormal model, it is shown that IT could be subject to credibility problems s imilar to those found in exchange rate-based stabilization programs.