Dollarization as a Signaling Device

This paper studies optimal dollarization. In the standard model government con- ducts an optimal policy and dollarizing does not improve upon this policy. Here dol- larization is optimal. This paper modi…es the standard approach by introducing two types of government: good and bad. Good government wants to conduct an optimal policy, bad government wants to …nance higher (than optimal) government expendi- ture by printing money. People do not observe the type of government, they know only the probability distribution over the government types. Good government, even if it performs the optimal policy, cannot achieve an optimal outcome, because of the uncertainty about the type of government. Thus good government dollarizes and bad government does not dollarize. As a result we obtain a separating equilibrium, when dollarization can be viewed as a signaling device.