"Dollarization, Bailouts and the Stability of the Banking System"
 

Abstract: We examine the trade-offs associated with the move to dollarization from the perspective of the stability of the banking system in a small open economy. Central bank policy suffers from time-inconsistency when facing a banking crisis: A bailout is optimal ex post but ex ante it should be limited to control moral hazard. Dollarization provides credible commitment not to help at the cost of not helping even when it would be ex ante optimal to do so. It is found that in the presence of moral hazard, dollarization is good when the costs of establishing a reputation for the central bank are high, monitoring effort by the banker is important in improving returns, and when the cost of liquidating projects is moderate. However, a very severe moral hazard problem could make dollarization undesirable.