Financial dollarization, the portfolio approach, and expectations: Evidence for Latin America (1995–2005)

This article examines the persistence of financial dollarization in Latin America between 1995 and 2005, using the portfolio model proposed by Ize and Levi-Yeyati. It is argued that agents’ choice of dollar-denominated assets is influenced by the relative volatility of inflation and the real exchange rate, and the effect of expectations on the degree of dollarization is investigated. The methodology employs a panel data model that includes 15 countries and modifies the variance matrix to assess short- and long-run memory. The results suggest that the portfolio model can explain part of the dollarization, but its predictive power decreases when a short-memory approach is considered. It was found that the response of dollarization to changes in volatility is significant for economies that are not highly dollarized, but minimal for those that are. This finding suggests that monetary policy should focus on managing historical expectations to address the persistence of dollarization. (Abstract and audio: Department of Economic Publications)