Escaping the Financial Dollarization Trap: The Role of Foreign Exchange Intervention
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Summary:
Financial dollarization is considered a source of macroeconomic instability in many emerging economies. Dollarization constrains the ability of central banks to stimulate output during economic downturns. In contrast to the conventional monetary transmission mechanism, a monetary policy loosening in a dollarized economy leads to a currency depreciation, adverse balance sheet effects, and a contraction in investment and output growth. In this paper we evaluate the role of foreign exchange reserves in facilitating macroeconomic stabilization in a financially dollarized economy. We first show empirically that foreign exchange intervention in response to capital outflows can largely reduce the volatility of output and the real exchange rate in dollarized economies. We then develop a small open economy model with foreign currency debt and balance sheets effects. Our quantitative model shows that an active foreign exchange intervention policy is sufficient for offsetting the output volatility associated with financial dollarization. These results can explain the prevalence of low macroeconomic volatility in some dollarized economies (Christiano et al., 2021) and they highlight the role of foreign exchange reserves in reducing the welfare costs of dollarization.
Series:
Working Paper No. 2024/127
Subject:
Balance of payments Capital flows Capital outflows Central Banks Dollarization Foreign exchange Foreign exchange intervention International reserves Monetary policy
Frequency:
regular
English
Publication Date:
June 21, 2024
ISBN/ISSN:
9798400280795/1018-5941
Stock No:
WPIEA2024127
Format:
Paper
Pages:
39
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