Interestingly enough, not only dollarization, reduces almost
completely the scope for monetary policy, but also curtails the
ability to pursue fiscal policy. In effect, when debt is
denominated in domestic currency the central bank, which acts as
the fiscal agent of the treasury, can always monetize it. If we
leave for aside for now the consequences of monetization (I’ll
deal with that in another post), default in domestic denominated
debt is not possible, since monetization is always an option.
Dollarization transforms all debt (public and private) into
foreign debt, and as the central bank cannot print foreign money
(if we rule falsification out), default risk is incremented
(supposedly in exchange foreign exchange risk vanishes, since
nominal depreciation is impossible in a dollarized economy). As
result, not only contractionary fiscal policy has to be used to
reduce the demand for imports if there are external problems,
but also the space for domestic spending (not the external
transactions that would alw