Endogenous Dollarization, Expectations, and Equilibrium Monetary Policy∗

Emerging market countries have trouble ßoating, and many that claim to ßoat do not deliver on such promises. That is a main conclusion of much recent empirical work, starting with the papers of Calvo and Reinhart (2002) and Stein et al (1999). The reason for this would seem to be dollarization of liabilities and balance sheet effects. Calvo (1999 and 2000), Krugman (1999 and 2000), Stein, Hausmann, Gavin, and Pagés-Serra (1999), and Aghion, Bachetta and Banerjee (1999), among others, make that case. If debts are denominated in dollars while Þrms depend on local currency revenues (or, more precisely, revenues increase with the relative price of goods produced at home), sharp and unexpected changes in relative prices matter for Þnancial stability. The policy conclusion that emerges from this line of work is that ßexible exchange rates can be destabilizing, and therefore emerging market nations would be well advised to design alternative arrangements, including currency boards and dollarization. Such a view has become extremely inßuential. But even its most ardent advocates understand that it is only half the story. The claim is that ßoating is infeasible for a given dollarized debt portfolio. But of course portfolio choices — for instance, what shares of debt to hold in peso and dollar-denominated bonds— depend on the risk-return characteristics of these securities, which in turn depend on the structure of shocks and expected monetary and exchange rate policies. Following standard asset pricing and portfolio choice models, variances and covariances (especially with consumption) should matter. Several authors —Ize and Levy-Yeyati (2003), Ize and Parrado (2003) and Morón and Castro (2003) among others— have recently used this approach, in partial equilibrium, to model endogenous dollarization in emerging markets. ∗Preliminary and incomplete. Comments welcome. Prepared for the San Francisco Fed Emerging Markets Conference, June 2004. We are grateful to the National Science Foundation for Þnancial support. †Email: [email protected] ‡Email: [email protected]