A loyal and possibly even addicted MR reader writes:
El Salvador has been dollarized since 2001. What the overwhelming majority of Salvadorans tell me is that, *everything is much more expensive since we switched to the dollar.* Now I feel like this cannot be wholly true. For sure the transaction cost of receiving remesas has been reduced (is the reduction significant to the individual receiving $200 a month?), it will protect against volatile inflation, and eliminate any double currency issues, but I have little more understanding than that. El Salvador’s monetary policy decisions are now made in Washington, D.C. and thus not all of the policies made will be in the best interest of El Salvador, but would it be naïve to believe that prices have not actually risen any more than they normally would have with the colon?
I too felt that El Salvador was relatively expensive for its income level, as is Panama. (I haven’t been to Ecuador since the shift to the dollar, but that is an obvious natural experiment.) But why?
1. Dollarization makes the El Salvador exchange rate hostile to strong "reserve currency" demands for dollars.
2. Dollarization makes it easier to compare prices with the U.S., which leads to more arbitrage, different expectations, and could be inflationary. I know that sounds lame, but we have seen similar effects in the Eurozone.
3. The trick is to figure out whether the Bela Balassa argument applies. In 1964 Balassa noted that an exchange rate is determined mostly by a country’s tradeables. So if compared to the U.S. El Salvador is less productive in tradeables, but comparably productive in some untradeables (e.g., haircuts), the haircuts will be especially cheap in El Salvador. U.S. productivity in tradeables makes the dollar very strong in terms of the non-tradeables. That’s one reason why people go to Thailand for you-know-what.
Think of the El Salvador haircut as (previously) cheap for two reasons: low real wages in El Salvador, and the dinky value of the (former) colon. When El Salvador moves to the U.S. dollar, the latter reason goes away and the haircut becomes more expensive.
You might think that everything should be neutral in terms of the currency unit, but the demand for money matters too. This means the Balassa effect is a special case of #1 above.
So, following dollarization, the relative price of the El Salvador non-tradeables is higher for people coming from the United States. Those relative prices are also higher for El Salvadorans working in their country’s tradeables sector.
Or so I believe. I’ve been worrying about this one for weeks, folks. Get a life!
#23 in a series of 50.
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If Ecuador’s local economy runs on the dollar, prices will be determined by the relative supplies of goods and the local supply of dollars. Exchange rates will be of no consequence except to the extent that they may result in the arbitrage of either money or goods.
If Ecuador has a current account surplus with dollar-based trading partners, or it receives dollars from expatriates abroad, in either case the dollar price inflation of goods will exceed even the inflation determined in Washington by the FED.
Regards, Don
There’s no reason a currency change should effect the real price of nontradables: whether you spend dollars or colon, you can still only cut 8 heads of hair a day. The price of tradables can certainly differ by currency, though, since PPP doesn’t hold empirically (especially over short horizons).
A simpler explanation might be that the price increase is illusory. Inflation in Ecuador has been 3-5% the last few years, which is below average for Latin American countries. Perhaps this inflation has been concentrated in “everyday purchases” (imagine milk and gasoline in the US). I have no reason to doubt the real growth and inflation figures for ES, so…
If a new single plant, a ‘sweatshop’ for example, is introduced to Ecuador and only local labor is a production factor, then the increased wealth of the workers will bid up the local prices of goods even if they are paid in a local currency. But if they are paid in new dollars from abroad, prices will rise even faster.
Regards, Don
“If Ecuador has a current account surplus with dollar-based trading partners, or it receives dollars from expatriates abroad, in either case the dollar price inflation of goods will exceed even the inflation determined in Washington by the FED.”
(The question was about El Salvador, but no importa…)
You’re neglecting the effects of trade with non-dollar partners. If I sell a bunch of shoes to the US and get a bunch of dollars for them, those dollars may never make it in to the local economy to affect haircut prices if I trade them for Yen to buy a bunch of VCRs.
In fact, local prices can rise even if there’s a current account deficit with dollar partners, as long as there’s a net current account surplus with all partners. It doesn’t matter what currency the trade is denominated in; the surplus currency earned by the net exports will be exchanged for dollars if it stays in the local economy (here assuming that El Salvador is the legendary “small open” economy, i.e. it’s a price taker in forex markets, not a price setter).
Remittances would work the same way. They’ll raise local prices even if they come from Salvadoristas living in Heidelburg sending back Euro.
I do think that everything should be neutral in terms of currency, even the Belassa argument. Tradeable/non-tradeable productivity differences can explain price differentials between any two areas no matter what currencies are in use there. So can differences in income. If you’re wondering what could make prices rise in El Salvador compared to the US, ask the same question about Arkansas compared to California and you’ll find your answers.
As to why there might be a jump in prices after a switch to dollarization… maybe some sectors were priced inefficiently beforehand, and switching to dollars has improved things, with the price hikes being in visible areas and the price cuts being elsewhere. Or maybe prices were efficient beforehand, but the pricing confusion due to the switch introduced inefficiencies which haven’t yet worked themselves out.
Could the inflow of drug money (either attracted by the laundering possibilities in a dollarized economy or directly by the country’s participation in the drug trade) be part of the explanation?
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