Dollarization and Price Dynamics
Penaloza, Roberto V.
This study contributes to the scarce empirical literature on dollarization by investigating the short and long-run effects of dollarization on the dynamics of prices at the macro and the micro level. This study also presents a survey of the available literature. This study examines the short-run stabilizing effects of a credible system like dollarization in the context of Ecuador, a country that dollarized in January 2000. Using monthly data for the period from January 1995 to April 2003, this study shows how the adoption of dollarization put an end to the Ecuadorian 1999 currency crises, and allowed prices in Ecuador relative to the U.S. to return to pre-crisis levels, not only at the aggregate but also at the commodity level. Also with dollarization, 11 Ecuadorian cities became more integrated with the capital city, Quito, in terms of price levels. This result, however, does not imply an overall price integration of the cities with one another. A stronger result is that dollarization has produced a “narrowing of the border” between Ecuador and the U.S., and between Quito and the other Ecuadorian cities in terms of reduced price volatility. This study examines long-run price level convergence in the context of Panama, a country that has been dollarized since 1904. The results of a comparative analysis of Panama and 12 non-dollarized Latin American countries using annual data for the period 1950-2000 indicate that the volatility of Panama’s relative price level with respect to the U.S. has been outstandingly low. However, dollarization has not contributed to rapid economic growth in Panama. In addition, for both Panama and the “average” non-dollarized Latin American country, the real exchange rate shows a tendency to depreciate over time, violating long-run Purchasing Power Parity, and implying a divergence of price levels with respect to the U.S. The countries’ price levels have instead converged to a positive, Balassa-Samuelson-type relationship with their income levels, which implies that Panama’s price level is explained by its per-capita income, and no extra effect can be attributed to dollarization.