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How strong is the case for dollarization in Central America? An empirical analysis of business cycles, credit market imperfections and the exchange rate
Author(s) -
Lindenberg Nannette,
Westermann Frank
Publication year - 2012
Publication title -
international journal of finance and economics
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 0.505
H-Index - 39
eISSN - 1099-1158
pISSN - 1076-9307
DOI - 10.1002/ijfe.446
Subject(s) - economics , business cycle , exchange rate , monetary economics , currency , boom , bond market , keynesian economics , environmental engineering , engineering
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 boom–bust 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 © 2011 John Wiley & Sons, Ltd.