Ricardo Cardona 

Monetary Policy Constraints
in an Small Open and Dollarized Economy


Central Banks around the world use monetary and exchange rate policies to affect interest rates aggregate output and internal credit in the short run.[1]  Nonetheless, in small open economies these tools have limited efficiency, since global markets determine interest rates. Many small economies use fixed exchange rate policies to control inflation or promote stabilization. This policy puts constraints on the use of monetary tools that increase aggregate output because money supply change is subject to a determined exchange rate. Furthermore, in some small economies people prefer to hold dollars rather than domestic currency to avoid exchange rate risk.  This phenomenon, called dollarization, may be beneficial in processes of stabilization and price controls.  Nonetheless, dollarization puts further constraints to the use of monetary policy tools. Moreover, this economic context prevents an efficient distribution of credit.  When a country is dollarized, its reserves of dollars represent a ceiling of credit. Thus, this phenomenon constraints any attempt to redistribute credit through the generation of money.  Consequently, although dollarization prevents inflation and promotes macroeconomic stability, it prevents the Central Bank from coping with external shocks and affect aggregate output. Moreover, it restricts the Central Bank in its task to control the internal credit, which in turn prevents an efficient distribution of credit. 

[1] Certainly, this Keynesian view is very arguable and many economists do not support it. Nonetheless, for simplicity we assume certain effectiveness of monetary and exchange rate policies in the short run


A case Study:  Bolivian Stabilization Process after 1985

Bolivia has a small open economy, which is still recovering from its debt crisis in the 80s.  The government applied orthodox policies to stop inflation and adjust the budget.  These policies achieved positive results on price stabilization; however, unemployment and GDP growth were hindered.  One of the main outcomes of this crisis was the dollarization of bank accounts, which gave more confidence to the public.  The real demand for bolivianos declined, since people preferred to hold dollars.  Nonetheless people were still doing transaction in bolivianos, which generates inflationary pressures under monetary expansion.   Moreover, Bolivia carries a crawling peg exchange rate, which restricts the effectiveness of monetary policy tools because the central bank must peg the boliviano to the dollar.  To analyze the Bolivian economic context, we need to formalize and fit the effects of dollarization into a macroeconomic model.  The most appropriate model for the Bolivian economic context is The Mundell-Fleming model, since Bolivia is a small and one of the most open economies in the region[1]

[1] Currently Bolivia has the lowest tariffs in the region and has no restriction on the flows of capital 


Under the Mundell-Flemming model, Bolivia would have a vertical LM curve because the interest rate is constant and exogenously given.  Under the Mundell Flemming model, when the central bank uses monetary policy, it shift the vertical LM curve to the right, which lowers the exchange rate, increases net exports and aggregate output (see exhibit 1)[1].  Nonetheless, in a dollarized economy that carries a crawling peg exchange rate, the outcome of this model differs from the conventional floating rate regime.  The crawling peg system prevents random movements in monetary supply because the domestic currency in Bolivia must follow the dollar.  The central bank auctions dollars every day setting the base price for dollars.  Thus, the central bank allows mini devaluations while pegging the dollar.  We can consider this a semi fixed exchange rate.  Consequently, under the Mundell-Fleming model any increase in money supply that shifts the LM leftwards is practically ineffective. After a monetary expansion under a semi fixed exchange rate system, the central bank would have to decrease money supply to maintain parity with the dollar.  This would move the LM leftwards thus offsetting the output gains of monetary expansion (see exhibit 1). 

[1] Macroeconomics.  Aggregate Demand in the Open Economy, Chapter 12


Exhibit 1 [1]

Mundell-Fleming Model under a Crawling-Peg Exchange Rate

[1] Macroeconomics.  Aggregate Demand in the Open Economy, Chapter 12


A further limitation of Monetary Policy under the Mundell-Flemming model is dollarization.  One of the main costs of dollarization is the inflationary consequence of monetary expansion and exchange rate movements.  In Bolivia, the pass-through effect between depreciation of the exchange and inflation is a non-linear relation, which decreases when depreciation rates are low.  For depreciation rates of 0.5%, the pass-through effect is approximately 60%[1].  This high percentage is a consequence of dollarization, since people can easily switch from bolivianos to dollars when there are expectations of devaluation, thus causing inflation.  Consequently, under a dollarized economy, the Bolivian Central Bank will prevent any movement of the LM curve rightwards because this means a lower exchange rate, which translates into inflation very quickly.  In this context, the role of the central bank in small, open and dollarized economies is very limited.  Nevertheless, the Mundell Fleming model cannot show one of the main costs of dollarization, which is distribution of credit. 

[1] Banco Central de Bolivia annualized Report.  Lecturas in Politica Economica

The distribution of wealth in Bolivia is very unequal, as it happens in most countries in Latin America. Supposedly, one of the main roles of the central Bank in Bolivia is the proper management of internal credit.  Joseph Schumpeter proposed the idea of distribution of credit by expanding money supply.  Schumpeter claims that although a monetary expansion will lead to inflation, it will reallocate credit towards more efficient production[1].  In the Latin American economic context this idea seems very “populist”.  Nonetheless, we should not interpret Schumpeter’s idea on credit redistribution as a radical shift of wealth from some group in society to another.  In our analysis Schumpeter’s idea of distribution of wealth would be an instrument for the central bank to oversight and regulate the banking system. 

[1] Kyn, Oldrich. Paper on Joseph Schumpeter 


In Bolivia, credit reaches only 15% percent of the urban population[1].  According to Schumpeter’s ideas, adequate expansions of money supply could gradually change this tremendous inequality.  In Bolivia, dollarization restricts this task because the banks’ assets and liabilities are mostly in dollars.  The counterpart of these assets and liabilities are the countries reserves of dollars.  Any expectations of banking instability directly affect the level of international reserves. For example, in the elections of 2002 the level of reserves decreases by 25% in two weeks because of bank runs.  Dollarization of bank deposits limits the distribution of credit because the central bank cannot issue dollars at will.  The level of dollar reserves depends exogenously on exports or international aid. 

[1] Banco Central De Bolivia, Statistic Data 2002,

After an analysis of the negative aspects of dollarization the question to ask is why countries, such as Ecuador or Argentina tend to dollarize?  In an uncertain environment, dollarization is sign of price stability.  In the case of Ecuador, the government promoted total dollarization, since the demand for Sucres was very low after a political turmoil.  In Argentina, many politicians are proposing total dollarization, since the demand for national currencies is very low.  We can see, that dollarization is useful as a stability measure or an anchor for inflation.  Nonetheless, this phenomenon can lead to a loss of monetary independence such in the case of Bolivia.  We can see in this case that after a credible stabilization process of 17 years, dollarization is not beneficial because it puts constraints on the main tools of the central bank.


The Bolivian case fits macro economic models very well and shows how the role of central banks in small open economies differs from that of an industrialized one.  In a small open economy, the central bank’s main tool to affect aggregate output is the exchange rate rather than the interest rate, since the latter is exogenously given.  We saw that in a semi fixed exchange rate, such as the one in Bolivia, monetary policy is not as effective as in a floating exchange rate regime, thus putting further constraints to monetary policy.  Furthermore, in a dollarized economy a monetary expansion translates very rapidly into inflation. The costs of dollarization transcend into credit distribution because banks and people demand dollars. Banks assets and liabilities depend on the country dollar reserves, which in turn does not depend on the central bank.  Dollarization is a consequence of people loosing faith in monetary institutions.  In the short run, dollarization may be beneficial as an anchor for stability and price controls; however, in the case of Bolivia we saw that the costs of dollarization outweigh its benefits after a credible process of stabilization.



1) Kyn Oldrich, Paper on Joseph Schumpeter.

2) Aggregate Demand in the Short Run, The Mundell-Flemming Model, Chapter 12

3) Bolivian Central Bank annualized Report, Lecturas en Politica Economica, 2002 

4) Bolivian Central Bank Economic Data,      




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