DOES DOLLARIZATION ALLEVIATE OR AGGRAVATE EXCHANGE RATE VOLATILITY?

Relying on hard currency or dollarizing an economy has been a common practice of many developing countries taking the form of dollarizing bank deposits and loans, settling transactions in dollars and the indexation of wages and prices in dollars. The relationship between dollarization and exchange rate volatility is both theoretically and empirically unresolved. While the effect of such practices has been the focus of numerous investigations, such studies have concentrated on the Latin American and Asian economies. This paper contributes to the limited research on the African economies by specifically investigating the consequences of dollarization on Eritrean exchange rate volatility. Using quarterly official and black market exchange rate data for the study period 1996-2008, E-GARCH analysis suggests that dollarization has a positive impact on real exchange rate volatility.