Escaping the Financial Dollarization Trap: The Role of Foreign Exchange Intervention
IMF Working Papers, June 21, 2024
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- Escaping the Financial Dollarization Trap: The Role of Foreign Exchange Intervention
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Bibliographic details
- Authors: Paul Castillo, Ruy Lama, Juan Pablo Medina
- Published: June 21, 2024
- Series: IMF Working Papers
- DOI: https://doi.org/10.5089/9798400280795.001
Key problem and context
- 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 a financially dollarized economy, a monetary policy loosening leads to:
- a currency depreciation,
- adverse balance sheet effects,
- a contraction in investment and output growth.
Empirical findings
- Foreign exchange intervention in response to capital outflows can largely reduce the volatility of:
- output, and
- the real exchange rate,
in dollarized economies.
- These empirical results help explain the prevalence of low macroeconomic volatility in some dollarized economies (Christiano et al., 2021).
Theoretical and quantitative model results
- The authors develop a small open economy model with:
- foreign currency debt, and
- balance sheet effects.
- The quantitative model shows that an active foreign exchange intervention policy is sufficient for offsetting the output volatility associated with financial dollarization.
- The results highlight the role of foreign exchange reserves in reducing the welfare costs of dollarization.
Policy implications and recommendations
- Active foreign exchange intervention (using international reserves) can be an effective tool to stabilize output and the real exchange rate in financially dollarized economies.
- Holding and deploying foreign exchange reserves mitigates the adverse balance sheet and macroeconomic effects stemming from capital outflows in dollarized contexts.
- Policymakers in emerging, dollarized economies should consider foreign exchange intervention policy design as part of their toolkit to reduce the welfare costs associated with dollarization.
Publication and metadata
- Authors: Paul Castillo, Ruy Lama, Juan Pablo Medina
- Date: June 21, 2024
- Series: IMF Working Papers
- Issue: 127
- Volume: 2024
- Pages: 39
- DOI: https://doi.org/10.5089/9798400280795.001
- Stock No: WPIEA2024127
- ISBN: 9798400280795
- ISSN: 1018-5941
- Subjects: 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
Source: "Escaping the Financial Dollarization Trap: The Role of Foreign Exchange Intervention", Paul Castillo; Ruy Lama; Juan Pablo Medina; IMF Working Papers 2024, Issue 127.
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- Working Paper