Optimal Central Bank Areas, Financial Intermediation, and Mexican Dollarization

This paper argues that the most important effects of Mexican dollarization would operate not through the standard "optimal currency area" channels, which involve gains from reducing costs of translating and exchanging currencies, or from stabilization of business cycles. Nor would it operate through possible welfare improvements from dollarization as a commitment device for monetary policy. Instead, it would operate through the effects of dollarization on financial intermediation, investment, and economic growth. In particular, dollarization-like adoption of the euro-would involve not only a change in the currency used to quote prices, perform accounting, and make transactions, but also a change in the central bank (for Mexico), with attendant changes in supervision, regulation, and monetary policies that, by affecting incentives of banks and other financial intermediaries, would affect the amount of financial intermediation and therefore overall investment and growth. Examples drawn from various theories of financial intermediation illustrate how the scale of intermediation can be affected by central bank policies, and how this affects the costs and benefits of dollarization.