Fiscal Consequences for Mexico of Adopting the Dollar

Dollarization implies a reduction in the menu of assets available to the government and to the private sector in managing risk. Whatever the gains from dollarization, the costs of reducing the asset menu need to be weighed against them. This paper presents models, one a simple generalization of a well-known model of tax smoothing by Ba1ao, in which these costs are explicit. Along the way, it suggests that there is likely to be no reduction in interest costs to the government from dollarization. RECENTLY ECONOMISTS have been paying increasing attention to a dynamic general equilibrium approach to the theory of the price level that is often called the fiscal theory of the price level, or FTPL. This way of thinking emphasizes the role of fiscal and monetary policy in determining the risk and return properties of government liabilities. It is particularly useful in analyzing proposals for large-scale institutional changes that imply shifts in monetary and fiscal policies. When dollarization is considered from this perspective, some disadvantages are brought to light that may not be so apparent from other points of view. Section 1 below lays out the main ideas of FTPL. Section 2 displays a model that extends an earlier one of Barro's to argue that optimal fiscal policy will use surprise inflation to achieve lower deadweight tax loss than would otherwise be possible. Section 3 considers the composition of government liabilities along the lines of the theory of corporate finance, asking if dollarization will reduce the cost of funds. Section 4 presents annual estimates of the unanticipated returns to holders of U.S. government debt, to show that these are substantial and are to some extent timed to match legitimate periods of fiscal stress, as the optimality theory of section 2 would suggest. Section S discusses the lendel of-last-resort function and its connection to these fiscal issues. Section 6 briefly discusses some alternatives to pure dollarization. In our concluding section 7 we sum up, finding much to worry about in the prospect of dollarization.