Financial Dollarization and Effective Monetary Policy Autonomy: Evidence from Highly Dollarized Economies

Financial dollarization does not necessarily deprive central banks of control over their policy instruments, but it may limit their ability to influence domestic financial conditions, a distinction not fully captured by existing measures of central bank or monetary independence. This paper develops an index of Effective Monetary Policy Autonomy (EMPA) that distinguishes policy autonomy, reflected in the independence of domestic from anchor-country interest rates, from policy effectiveness, assessed through price stability and the transmission of interest-rate changes to domestic credit. Using an unbalanced panel of 19 highly dollarized economies over 1994–2023 and two-way fixed-effects estimation, we find no significant association between deposit dollarization and monetary policy autonomy, but a marked weakening of credit transmission. A one-standard-deviation increase in deposit dollarization reduces the credit-transmission component by approximately half a standard deviation. The result is robust across specifications and index constructions and strongest under fixed or tightly managed exchange-rate regimes. Deposit dollarization and credit transmission are both persistent, but the effect of dollarization shows no threshold, asymmetry or dependence on past peaks, although it rests largely on the largest de-dollarization episode in the sample. These findings suggest that dollarization primarily constrains the effectiveness of monetary transmission rather than monetary policy autonomy itself.