Dollarization and the integration of international capital markets - A contribution to the theory of optimal currency areas

We consider the following questions: (1) Does the adoption of a common curr ency either reduce or enhance the scope for endogenously generated volatili ty to emerge? (2) Does the adoption of a common currency reduce or enhance the scope for indeterminacies to arise? (3) Is there a welfare justificatio n for the adoption of a single currency? (4) What are the fiscal consequenc es of a move to a single currency? We address these issues in a two-country model with both a transactions role and a store-of-value role for currency . Moreover, banks arise endogenously in each country. In this context we co mpare the determination and characteristics of an equilibrium in each of tw o situations: one where each country issues its own currency, and one where one of the countries adopts the currency of the other country. The consequ ences of this "dollarization" depend very much on the degree of integration of the capital markets of the two countries. When their credit markets are poorly integrated, a regime with two currencies displays a unique stationa ry equilibrium. Dollarization, under very weak conditions, gives rise to a continuum of equilibrium paths. These may exhibit oscillation. Hence, when capital markets are segmented, dollarization may be a source of indetermina cy and endogenously arising volatility. In addition, the welfare justificat ions for dollarization are weak, and dollarization my have adverse fiscal c onsequences. When credit markets are fully integrated internationally, the results are substantially different. In that case, both regimes display a u nique equilibrium path. Hence, in the presence of unrestricted internationa l capital flows, the adoption of a common currency does not affect the scop e for indeterminacy. However, dollarization may still-albeit under relative ly extreme conditions-allow "excess volatility" to be observed.