Pass-through in dollarized countries: should Ecuador abandon the U.S. Dollar? [WP]

Abstract

In this article we examine the convenience of dollarization for Ecuador today. As Ecuador is strongly integrated financially and commercially with the United States, the exchange rate pass-through should be zero. However, we sustain that rising rates of imports from trade partners other than the United States and subsequent real effective exchange rate depreciations are causing the pass-through to move away from zero. Here, in the framework of the Vector Error Correction Model, we analyse the impulse response function and variance decomposition of the inflation variable. We show that the developing economy of Ecuador is importing inflation from its main trading partners, most of them emerging countries with appreciated currencies. We argue that if Ecuador recovered both its monetary and exchange rate instruments it would be able to fight against inflation. We believe such an analysis could be extended to other countries with pegged exchange rate regimes.