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We consider the following questions: (1) Does the adoption of a common currency either reduce or enhance the scope for endogenously generated volatility to emerge? (2) Does the adoption of a common currency reduce or enhance the scope for indeterminacies to arise? (3) Is there a welfare justification for the adoption of a single currency? (4) What are the fiscal consequences of a move to a single currency? We address these issues in a two-country model with both a transactions role and a store-of-value role for currency. Moreover, banks arise endogenously in each country. In this context we compare the determination and characteristics of an equilibrium in each of two situations: one where each country issues its own currency, and one where one of the countries adopts the currency of the other country. The consequences of this "dollarization" depend very much on the degree of integration of the capital markets of the two countries. When their credit markets are poorly integrated, a regime with two currencies displays a unique stationary equilibrium. Dollarization, under very weak conditions, gives rise to a continuum of equilibrium paths. These may exhibit oscillation. Hence, when capital markets are segmented, dollarization may be a source of indeterminacy and endogenously arising volatility. In addition, the welfare justifications for dollarization are weak, and dollarization my have adverse fiscal consequences. When credit markets are fully integrated internationally, the results are substantially different. In that case, both regimes display a unique equilibrium path. Hence, in the presence of unrestricted international capital flows, the adoption of a common currency does |
