Macroeconomic effects of dollarization in El Salvador

Abstract

We examine the effects of dollarization on El Salvador's macroeconomy and test whether they have been consistent with standard theoretical predictions. Our evidence suggests that the answer is mostly affirmative. In particular, consistent with the theory, we find that dollarization reduced both the average inflation rate and inflation volatility in El Salvador. Also consistent with theory, this was accompanied by lower business-cycle volatility and without statistically significant effects on trend growth in El Salvador. Contrary to the "endogeneity" hypothesis, however, El Salvador's originally positive business-cycle correlation with the US decreased (and likely became negative) after dollarization.