Juan Sebastián López Almirante

Emerging market governments hold large stocks of U.S. dollar-denominated debt, while local-currency bond markets are intermediated by global financiers with limited risk-bearing capacity. I develop a Fiscal Theory of Exchange Rates (FTER) by embedding monetary-fiscal interactions in a small open New-Keynesian economy with this structure. Three results emerge. First, the conditions for monetary and fiscal dominance extend to the open economy, with regime boundaries shifting with the currency composition of debt and market segmentation. Second, under fiscal dominance, the exchange rate acquires a fiscal component: it adjusts to satisfy the government's budget constraint through a valuation channel — revaluing dollar liabilities — and a compensation channel, because global financiers require higher excess returns as sovereign borrowing rises. Contractionary monetary policy therefore generates depreciation and inflation rather than appreciation and disinflation. Third, the welfare cost of fiscal dominance grows convexly with dollar-debt exposure and segmentation, while both are essentially irrelevant under monetary dominance.

The welfare costs of dollarization trade off the benefit of lower inflation against the cost of the loss of seignorage, the cost of the initial open market operation to purchase the money supply, and the increased probability of default induced by the first two. We evaluate the welfare costs of dollarization in a small open economy model of defaultable debt with money and international reserves calibrated to Ecuador, which dollarized in 2000. The welfare cost of dollarization in an economy with 20% of debt-to-GDP can be as high as 1.75% of permanent consumption. This cost can be expressed in terms of a break-even permanent level of inflation that increases non-linearly between 40% and 275% with the stock of initial debt. We also compute conditional default probabilities between a dollarized and a local currency economy and find that dollarization can lead to increased default incentives, particularly in the short run, highlighting that the initial stocks of debt, reserves and money matter.