How Much Bang for the Buck? Mexico and Dollarization

Abstract

Two arguments advanced in favor of Mexico abandoning the peso and adopting the U.S. dollar are to lower exchange rate volatility and inflation. We are not able to identify an independent link between economic growth and either the exogenous component of exchange rate volatility or the exogenous component of inflation. Exchange rate volatility generally reflects other factors, rather than representing an independent growth determinant. The findings are consistent with theoretical predictions that inflation influences growth by affecting financial development. However, we present suggestive evidence that legal reforms offer greater financial development dividends for Mexico than adopting the dollar. Two OF THE MAIN ARGUMENTS advanced in favor of Mexico abandoning the peso and adopting the U.S. dollar are (1) to lower inflation (and inflation uncertainty) and (2) to reduce exchange rate volatility. From 1960 tol995, Mexico's annual inflation rate averaged about 24.5 percent, while inflation in the United States averaged 5.5 percent. In addition, Mexico has experienced severe exchange rate fluctuations against the dollar, especially in the last fifteen years. Supporters of complete believe that reducing the rate of inflation (which moves very closely with the volatility of inflation) toward U.S. levels and eliminating exchange rate variability vis-a-vis the U.S. dollar will enhance the business climate and thereby promote economic performance. If lower inflation rates and less exchange rate variability boost growth, then this strengthens the case for dollarization. If, however, inflation and exchange rate variability do not exert large impacts on economic activity, then the arguments in favor of dollarization must be sought elsewhere. Besides inflation and exchange rate volatility, policymakers must contemplate an array of factors in deciding on dollarization. Dollarization would eliminate discretionary monetary policy and limit lender of last resort facilities during financial sec