Escaping the Financial Dollarization Trap: The Role of Foreign Exchange Intervention

By Paul Castillo, Ruy Lama, Juan Pablo Medina

June 21, 2024

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Paul Castillo, Ruy Lama, and Juan Pablo Medina. Escaping the Financial Dollarization Trap: The Role of Foreign Exchange Intervention, (USA: International Monetary Fund, 2024) accessed November 9, 2024

Disclaimer: IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management.

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.

Subject: Balance of payments, Capital flows, Capital outflows, Central Banks, Dollarization, Foreign exchange, Foreign exchange intervention, International reserves, Monetary policy

Keywords: Balance Sheet Effects, Capital flows, Capital outflows, Dollarization, Dollarization trap, Dollarized economy, Emerging Economies., Financial Dollarization, Foreign Exchange Intervention, FX intervention, Global, Global Financial Cycle, International reserves, Intervention policy, Liability dollarization

Publication Details

Pages:

39
Volume:

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DOI:

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Issue:

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Series:

Working Paper No. 2024/127
Stock No:

WPIEA2024127
ISBN:

9798400280795
ISSN:

1018-5941

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