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Monetary Integration and Dollarization

No Panacea

Edited by Matías Vernengo

This book deals with the economic consequences of monetary integration, which has long been dominated by the Optimal Currency Area (OCA) paradigm. In this model, money is perceived as having developed from a private sector cost minimization process to facilitate transactions. Not surprisingly, the book argues, the main advantage of monetary integration in the OCA context is the reduction of transaction costs, yet the validity of OCA to analyze processes of monetary integration seems to be limited at best.
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Chapter 12: From Capital Controls to Dollarization: American Hegemony and the US Dollar

Matías Vernengo


Matías Vernengo Introduction The recent turmoil in the world’s financial markets has prompted cries for innovative ways of dealing with uncertainty and volatile capital flows. The wave of financial crises from the Mexican Tequila to the more recent Argentinean one have only revived a long-standing debate on the merits of flexible versus fixed exchange rate regimes. The consensus for a while was that only corner solutions were efficient ways of dealing with capital flows (Fischer, 2001).1 In other words, countries should adopt either a rigid peg or a flexible exchange rate regime. In this view, dollarization is only an extreme form of a fixed peg, and as such is one possible alternative for emerging markets. In fact, some countries in Latin America have moved in that direction recently, most notably Ecuador and El Salvador. Further, several countries in the region maintained relatively fixed pegs with respect to the dollar for a good part of the 1990s, such as the Argentinean Currency Board. According to this definition of dollarization the decision to dollarize is based on the notion that the gains in economic efficiency arising from the elimination of transaction costs, and the reduction of risk arising from uncertain movements in exchange rates, outweigh the costs of dollarization. Those costs are associated with the loss of national sovereignty in conducting monetary policy. Interestingly enough the discussion of the effects of dollarization on the balance of payments adjustment have been neglected. An overview of the literature suggests that the conventional...

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