Does dollarization reduce or produce inflation?

Abstract

Purpose

The purpose of this paper is to address the unresolved outcome of the research on the impact of dollarization on inflation by examining the partially dollarized economy of Eritrea.

Design/methodology/approach

Inflation under partial dollarization is modelled based on money demand and supply framework. Using quarterly data for the study period 1996Q1-2008Q4, estimation is based on a vector error correction model together with dynamic ordinary least square.

Findings

The results indicate that inflation increases as a result of an increase in dollarization. This applies to both the short-run and long-run estimations regardless of whether official or black market exchange rate data are used in the analysis. In terms of the short-run dynamics involved in the long-run relationship between dollarization and inflation, the speed of adjustment toward long-run equilibrium ranges from negative 7.2-7.6 percent per quarter.

Research limitations/implications

The main policy implication of the finding is that the extent of dollarization should not be overlooked in controlling inflation in the short run and the long run.

Originality/value

Despite a number of studies that examine the consequences of dollarization, the impact of partial dollarization on inflation in the Eritrean economy has never been addressed. This study, therefore, is original in its kind and resolves the controversial outcomes on the studies of inflation and dollarization by modelling inflation under partial dollarization, providing new evidence and revealing potential economic reasons for the discrepancies in the findings of the literature on partial dollarization.

Citation

Mengesha, L.G. and Holmes, M.J. (2015), "Does dollarization reduce or produce inflation?", Journal of Economic Studies, Vol. 42 No. 3, pp. 358-376. https://doi.org/10.1108/JES-11-2012-0159