How strong is the case for dollarization in Central America? An empirical analysis of business cycles, credit market imperfections and the exchange rate

Abstract

In this paper, we contrast two different views in the debate on official dollarization. The Mundell framework of optimum currency areas and a model on boombust cycles, by Schneider and Tornell, who take account of credit market imperfections prevalent in middle income countries. We highlight that the role of the exchange rate is strikingly different in the two models. Although in the Mundell framework, the exchange rate is expected to smooth the business cycle, the other model predicts that the exchange rate plays an amplifying role. We empirically evaluate both models for eight highly dollarized Central American economies. We document the existence of credit market imperfections and find that shocks from the exchange rate indeed amplify business cycles in these countries. Using a new method of Cubadda, we furthermore test for cyclical comovement and reject the hypothesis that the countries form an optimum currency area with the United States according to the Mundell definition. Copyright (c) 2011 John Wiley & Sons, Ltd.