Does dollarization raise prices?

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.