Marginal Revolution: Dollarization

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Dollarization

Tyler suggests that dollarization raises prices. I am in Panama investigating. It´s true that the price of goods here, with the exception of some labor intensive goods like food preparation and taxi service, is similar to the U.S. Despite Tyler´s recondite arguments, however, I think dollarization lowers not raises real prices.

The argument to the contrary is mostly an illusion. When there is an exchange rate the nominal exchange rate can depart far from the real exchange rate. Over a matter of months a country can become very cheap or very expensive for tourists. The real exchange rate, however, is much more stable than the nominal exchange rate. So when dollarization fixes the nominal exchange rate a country is unlikely to become either very cheap or very expensive. Add in the selection argument that tourists visit when the country is cheap and its easy to see why it might appear that dollarization raises prices. (and for residents there is a selection effect also, dollarization happens when the country has been pushed to the wall.)

Overall, however, currency is mostly neutral and in the case of dollarization the effects if anything will be positive. For a country like El Salvador or Panama dollarization brings lower transaction costs and higher quality money which lowers real prices.

Addendum: Tyler, however, is correct about numero 6.

Posted by Alex Tabarrok on March 19, 2007 at 07:20 AM in Economics | Permalink

Comments

I bet a haircut costs more there than in Mexico...is that wrong? It is true that dollarization raises output, in the long run, but don't labor-intensive services become more expensive, as the Balassa theorem suggests?

Posted by: Tyler Cowen at Mar 19, 2007 7:51:37 AM

The Balassa argument has nothing to do with currencies. Local/non-local productivity differences (essentially, ground rent differentials) can explain deviations from purchasing power parity at any level, from local to international.

Posted by: anon at Mar 19, 2007 8:58:38 AM

Here's a way to reconcile Tyler and Anon's posts: Dollarization can raise ground rents by increasing the capitalized value of land. By reducing the risks of high inflation and currency depreciation, dollarization makes it easier for financial institutions to offer long-term mortgages at fixed rates, which broadens the class of borrowers. More borrowers mean more demand for property, translating to higer selling prices, higher rents, and higher prices for nontradables than would otherwise exist.

Of course, this chain of reasoning is abstract; it would require empirical investigation to determine how significant dollarization is for property prices in fact.

Posted by: Kurt Schuler at Mar 19, 2007 12:44:37 PM

Both Tyler and you are right about número 6. But both of you are wrong about the effects of dollarization on prices. I suggest that you look again at these effects but start with the simple example of what happens with prices across the 50 states and try to identify periods over which there have been important price differentials between one state and the others. Then you add Puerto Rico, then Panama and Liberia, but please try to look at what have happened over time. Then you can move to Ecuador, Hong Kong and other countries.
I know it's too much, but this only one reason why we haven't heard of anyone undertaking that type of study. The most important reason is that there are good theoretical reasons to believe that once all necessary adjustments have been made to observed price differentials (in particular, taxes), we are not going to observe persistent differentials. The only relevant issue is how fast prices adjust to a shock in just one or few states (oil shock to Texas and a few other states in 1986, California at the time of the last fiscal crisis), or in a dollarized country. We know that the speed of adjustment depends on other factors that may imply a much faster adjustment within the US than between US and Panama.
All recent examples of dollarization were countries with serious fiscal deficits that opted for dollarization to prevent the use of the inflation tax to finance the deficits. These countries failed to eliminate the deficits; whereas some were able to reduce them substantially, others had to find new ways to substitute for the inflation tax.

Posted by: Edgardo at Mar 19, 2007 2:57:03 PM

This article describes how dollarization in
third world countries is either rising or reducing
prices in these countries. With dollarization,
supply in demand for the country's currency no
longer is taken into consideration. Instead it is
pegged to the United States currency, reducing
exchange rate fees. This can be either good or bad
for the economy of these countries that are becoming\
dollarized because the country can become very cheap
nor very expensive.

Posted by: Jessica at Mar 19, 2007 11:21:28 PM

Thanks for talking sense on dollarization. If prices go up in a dollarized economy, well, so do wages. That's the whole beauty of the concept. So even if a haircut is higher in cost in Panama than in Mexico, a worker's wages to buy that haircut are higher too, because wages go up in tandem with prices under dollarization. Oh and notice that Panama doesn't have vast numbers of citizens seeking to become illegal immigrants. They can earn their dollars right there at home and don't need to go north to get them.

Posted by: A.M. Mora y Leon at Mar 20, 2007 6:39:17 AM

here

Posted by: bobby at Mar 24, 2007 2:52:48 PM

here

Posted by: bobby at Mar 24, 2007 2:54:24 PM

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