Essays on dollarized economies (Peru)

This dissertation includes three chapters, all of them related to dollarized economies. Chapter 1 discusses the concept of dollarization and shows that the previous literature has two problems: poor empirical measurement methods; and the lack of a clear definition of the phenomenon under study. We present a model based in the Divisia literature, in which monetary assets have different liquidity properties. In a dollarized economy this notion is important as we can distinguish two separate phenomena: currency substitution and asset substitution. The first one measures the share of total liquidity obtained from dollar-denominated assets. The second one is the share of total financial assets that is held in dollar-denominated assets. The model predicts a close relation between asset substitution and the interest rate differential and between currency substitution and the inflation rate differential. Using the Peruvian dollarization experience we found significant evidence supporting these hypotheses and reject the presence of hysteresis in the corrected currency substitution ratio.; Chapter 2 shows that highly volatile exchange rates are costly in economies with large liability dollarization ratios. This gives us reasons to believe that the Peruvian exchange rate could be characterized as a phony floater. Using an mlogit framework and a monetary policy reaction function, we found evidence suggesting an implicit defense on the level of the exchange rate. Going beyond the argument of fear of floating as a key explanation for this, we explore the reasons behind the fear and the need of following certain objectives in liability dollarized economies.; Chapter 3 argues that one distinguishable characteristic of emerging economies is that they are not financially robust. These economies are incapable to smooth out large external shocks as sudden capital outflows imply large and abrupt swings in the real exchange rate. Using a small open economy model we examine alternative monetary policy rules for economies with different degrees of liability dollarization. We answer the question of how efficient is to use inflation targeting under high liability dollarization. Our findings suggest that it might be optimal to follow a non-linear policy rule that defends the real exchange rate in a financially vulnerable economy.