This paper deals with dollarization and its role in the dynamics of inflation in Peru from January 1978 through December 1990.
The paper uses an error-correction model to show that a long-run relationship exists between the expected rate of depreciation in the black market exchange rate and the ratio of domestic money to an indicator of holdings of U.S. dollars; that is, the hypothesis of currency substitution can explain the behavior of real holdings of money in Peru.
The paper also shows that the importance of currency substitution as a transmission mechanism through which domestic fiscal and monetary policies affected the short-run behavior of inflation varied during the period under study. In fact, the estimation of a dynamic equation for inflation suggests that while the importance of the mechanism was relatively small during the period of high but relatively stable inflation (January 1978-85), currency substitution became more important during Peru’s recent hyperinflation. The paper then highlights the policy implications derived from the empirical results.