Understanding Dollarisation: A Keynesian/Kaleckian Perspective

ABSTRACT

What does ‘dollarisation’ mean in a world of endogenous money, i.e., in a world where money is not (only) created by printing pieces of paper, but (mainly) by making loans? Is it true that dollarisation only constitutes a limitation of sovereignty in the short run (making it harder to run standard stabilisation macro policies) or can it also slow a country’s growth process? To answer these questions, the paper builds a theoretical Keynesian-Kaleckian growth model for a dollarised economy within a framework of endogenous money. We will show that, ceteris paribus, the steady-state medium-term growth rate of a dollarised economy is lower than that of a country with its own currency. We will also show that a dollarised economy is more likely to be unstable than an economy with its own currency, in the specific sense that, everything else being equal, it is more likely for a dollarised economy to fall into a debt trap.

KEYWORDS:

• Dollarisation
• Keynesian macro models

JEL CODES:

• E12
• F41

Acknowledgements

Thanks to Elena Molho, Daniele Tori and Alberto Botta for useful comments. Thanks to my former colleagues at FLACSO Ecuador, Wilson Perez, Alberto Acosta and John Cajas, for our long discussions on dollarisation. Thanks also to the participants to the FMM Conference held in Berlin in October 2019 and the seminars given at Goldsmiths, University of London and at the University of Greenwich in February 2020. Remarks by Jan Toporowsky were especially useful. Above all, thanks to the two anonymous referees for their stimulating suggestions. Errors are my own responsibility.

Disclosure Statement

No potential conflict of interest was reported by the author(s).

Notes

1 According to the former Ecuadorian president, Rafael Correa (Correa Delgado, Rocca, and Ponsot 2019), the exchange rate is ‘the most important adjusting variable in a developing economy’.

2 Among the several papers on this topic, a useful examination can be found in Thirlwall (1997).

3 As stressed by the World Bank in a report on the West Bank and Gaza (World Bank 2008), this in itself could restrain the creation of loans needed in a growing economy. This simple observation would be enough to understand why dollarisation may slow medium-term growth, but in this paper we are going to use a different argument.

4 For a single bank, the other sources of funds are deposits and the interbank market.

5 Central banks in dollarised economies may only create reserves ex nihilo and lend them to private banks to the extent they are willing to increase national foreign debt, since they cannot print a piece of paper that has the status of legal tender. This makes them basically unable to control the interbank (‘overnight’) rate and then the overall structure of interest rates. Therefore, prevailing interest rates in dollarised economies are largely affected by the ‘world’ interest rate, i.e. the rate applied on funds borrowed from abroad. In other words, the interest rate is again exogenous (as claimed by the theory of endogenous money) but, instead of being decided by the domestic policymaker, it is decided by the foreign creditors. This is a huge difference.

6 Weintraub (1958) and Rowthorn (1977) are the pioneers of this ‘conflicting claim’ view of inflation.

7 Fields and Vernengo (2013) explain very clearly the reason why the US dollar remains unrivalled as the currency providing the world financial market with a risk free asset. This role does not come from sound (austere) macro policies. Rather, this is part of the ‘spoils of hegemonic power’: people accept US dollars and want them in order to feel safer because they know the United States require that key commodities are priced and traded, and transactions with US corporations are settled, in US dollars.

8 This ‘fundamental identity’ is far from obvious. The way it is written, it implicitly assumes that ‘our’ exports’ price is P (as can be seen from table FM), which is essentially determined by internal factors. However, as stressed by Taylor (1983, p. 128), ‘a pure primary product exporter would have its export price determined from abroad’, and therefore our model ‘can best be interpreted as referring to a semi-industrialised country’.

9 In this basic model, domestic bank loans are indeed the only way for domestic firms to finance accumulation (see Tables SM and FM).

10 For purely formal reasons, we prefer to use the word ‘industrialists’ (or managers) rather than ‘industrial capitalists’ because in our model there are no capitalists strictu sensu. Indeed, investments are fully financed by bank loans and non-financial firms distribute profits to managers’ households. There are no shares, and no shareholders. The same applies to banks: instead of referring to ‘financial capitalists’, we will generically talk of ‘bankers’. While adopting this terminology for the sake of formal clearness, it should be clear from (4) that there is a conflict between industrialists and bankers (industrial and financial capitalists) over the distribution of the surplus value.

11 For any given level of i*, q and L_f, an increase in GDP implies a higher GNI as well. Household consumption demand goes up and as a result imports of consumption items increase. Moreover, ceteris paribus a higher u increases the current profit rate and then improves profit expectations, thereby stimulating firms’ investment demand. This, in turn, will push imports of investment goods up.

12 The model is built in such a way that we cannot say much about the impact of a real depreciation. On the one hand, a higher q increases l_f, and, as we just saw, this has a recessionary impact. On the other, it might increase b₀ (provided that the Marshall-Lerner condition holds), which prompts an expansionary impact. A priori, the net effect is unclear, and the risk of a contractionary devaluation is always there, as first emphasised by Taylor and Krugman (1978) in their seminal paper on this topic.

13 This is clear from the very same formula for the macro profit rate: $r_s=\left(1-\psi \right)u_s-i^{\ast }$. The direct impact of the interest rate is negative, but in a creditor economy its indirect impact, working through variations in the utilisation rate, is positive.

14 Nothing relevant would change if we adopted a scheme of rational expectations (r = r^e).

15 The careful reader may have noticed that (12) is a little more restrictive than the short-run stability condition. A stable short-run adjustment does not guarantee medium-run stability.

16 This is exactly what happened in Ecuador at the end of 2014 when the world price of oil collapsed.

17 This is even more likely if we assume, realistically, that people react to the negative shock and the consequent economic downturn by rushing to the bank counter and increasing their preference for cash (the parameter α becomes endogenous). Again, this would only magnify a mechanism that in any case operates in a dollarised economy. Endogenising the parameter α is certainly crucial in an applied macro model, but not very important in the present theoretical framework.

18 Observe that along the stable branch of the rectangular hyperbola it is always v < v_D < 1 < 1/(1 – α), v_D being defined in the Appendix.

19 Needless to say, the growth of the profit share does not have to violate (12), otherwise internal instability would just replace external instability.

20 In a model where income distribution affects aggregate demand and output and growth happen to be ‘wage-led’ (Bhaduri and Marglin 1990), not even workers’ silence would be enough.

21 Observe that in S, v > v_D, but we do not if v > 1/(1 – α). This depends (and obviously so) on several other parameters of the economy.

22 The argument goes as follows: to be sure that the intercept continues to be negative, we should be able to say that i* > i₁, but we only know that i* > i₃. This would be enough when i₃ > i₁ but, as proved in the Appendix, for this to be true it must be α > α_H, with α_H < α_T. We only know that, in the case illustrated by Figure 4, α < α_T and therefore we cannot draw a conclusion.

23 The argument is essentially the same one as we developed in footnote 16. To be sure that the intercept becomes positive, we need α < α_H, but we only know that α < α_T, and α_H < α_T.

24 Observe, indeed, that in the steady state T we have v > v_N > v_D. In other words, the wealth-to-capital ratio is very high, as is the case for a creditor economy. That said, we cannot take it for granted that the economy at hand is a net creditor, since v > v_N certainly implies v > 1/(1 – α) only when α > α_T (i.e. in a regime of strong preference for cash), as the reader can easily prove by using the definition of v_N given in the Appendix.

25 In purely formal terms, this would only be possible when the intercept term of the investment function, g₀, is very high. The profit rate is negative, but industrialists keep accumulating capital (maybe in order to improve technologies and push competitors out of the market, but this is a story we do not deal with in this model).

26 Remaining in the realm of geometric intuition, the reader might note that Figures 2 and 6 on the one hand, and 5 and 9 on the other, are almost the same. This is clearly not true for igures 3–7 and 4–8. In other words, if the interest rate is very high (Figures 2–6) or very low (Figures 5–9), having a strong or weak preference for cash does not change significantly the likely dynamics of the economy. Out of these extreme cases, however, preference for cash becomes a key parameter.

27 The ambiguous effect on the wealth-to-capital ratio results from the existence of two different forces at work. On the one hand, there is a direct and negative effect on foreign debt: banks borrow more from abroad to satisfy households’ extra demand for cash. On the other hand, there is an indirect and positive effect on the accumulation of foreign debt: capital accumulation is now slower, and banks borrow less from abroad because they are lending less to domestic firms.

28 I borrow this expression from an acute observation by an anonymous referee.