Question

Why would Argentina have to give the United States seigniorage if it gave up its peso and completely dollarized its economy? How would you measure the size of Argentina's sacrifice of seigniorage? (To complete this exercise, think through the actual steps Argentina would have to take to dollarize its economy. You may assume that the Argentine central bank's assets consist of 100 percent of interestbearing U.S. Treasury bonds.)

Short answer

Argentina would have to give up seigniorage to the United States if it dollarized because it would no longer be able to issue its own currency and earn profits from money creation. The size of the sacrifice can be measured by calculating the foregone interest earnings from the central bank's assets, which are U.S. Treasury bonds.

Step-by-step solution

Understanding Seigniorage

Seigniorage is the profit made by a government by issuing currency, especially the difference between the face value of coins and their production costs. When a country adopts another's currency fully, in this case, Argentina dollarizing with the US dollar, it forgoes its own ability to print money, thus losing the seigniorage it would have otherwise earned on its own currency.

Assessing the Impact of Full Dollarization

To measure the size of Argentina's sacrifice of seigniorage, one could consider the total amount of money that the Argentine government would have been able to print and circulate at a profit in the absence of dollarization. This involves considering the interest that could have been earned on the reserves (held in U.S. Treasury bonds), which now would be converted into physical US dollars.

Calculating Sacrificed Seigniorage

The direct measure of seigniorage sacrificed would be the interest lost on the central bank's assets, as these assets would be liquidated into US dollars. To estimate the seigniorage loss, one would calculate the differential between the interest earned on the U.S. Treasury bonds that the central bank holds and the cost Argentina would incur to use US dollars (the opportunity cost of holding non-interest-bearing currency).

Key concepts

Full Dollarization

When a country decides to adopt another nation's currency entirely, a process known as 'full dollarization' occurs. It means the foreign currency fully replaces the domestic currency for all transactions. For Argentina, fully dollarizing its economy by adopting the U.S. dollar would mean the official renouncement of the Argentine peso.

By embracing full dollarization, Argentina would have to acquire U.S. dollars to circulate within its economy. Consequently, it would rely on physical U.S. dollars for every financial operation from lending in banks to everyday purchases, which would involve liquidating its assets, such as U.S. Treasury bonds, to acquire dollars.

The country would also lose its authority over monetary policy since it would no longer be able to influence its own currency's supply, interest rates, or exchange rates—powers typically wielded with autonomy by a sovereign central bank.

Issuing Currency

Issuing currency is a central aspect of a country's economic sovereignty. It enables a nation to control its money supply, manage inflation rates, and stimulate economic growth. Furthermore, currency issuance generates revenue through seigniorage—the difference between the cost to produce and distribute money and its face value.

The Argentine government would be forfeiting this prerogative with full dollarization. This decision would entail giving up the profits from seigniorage as it would no longer issue its currency. Instead, Argentina would need to obtain U.S. dollars from the external market, potentially at a significant financial cost.

U.S. Treasury Bonds

U.S. Treasury bonds are debt securities issued by the U.S. Department of the Treasury to finance government spending. They are regarded as one of the safest investment assets globally due to the perceived financial stability of the United States.

In the current context, the Argentine central bank's decision to hold its assets in U.S. Treasury bonds implies earning steady interest over time. However, to facilitate full dollarization, these bonds would need to be sold in exchange for U.S. dollars, forfeiting future interest payments. This trade-off is a significant factor when measuring the seigniorage Argentina would sacrifice upon dollarization.

Monetary Policy

Monetary policy involves the strategic management of a country's money supply and interest rates to control economic performance. Central banks use it to manage inflation, stabilize the currency, foster employment, and influence the overall economic health.

A fully dollarized country surrenders its monetary policy tools since it does not control the circulating currency—Argentina, for instance, would lose its ability to manipulate the peso's value or change interest rates to impact its economy. This means Argentina would be subject to the monetary policy decisions of the U.S. Federal Reserve, which would prioritize U.S. economic interests, not necessarily aligning with Argentina's economic needs.

Opportunity Cost

Opportunity cost is a fundamental economic concept referring to the potential benefits an individual, investor, or country misses out on when choosing one alternative over another. In terms of full dollarization, the opportunity cost for Argentina would be the benefits it forgoes by not holding onto its U.S. Treasury bonds and earning interest.

Moreover, the lost potential of employing a flexible monetary policy to address country-specific economic challenges must be considered as opportunity cost. For example, during economic downturns, Argentina would not have the capability to print money or adjust its financial parameters to stimulate the economy, as it could have done if it kept the peso. This restriction may come at a significant economic detriment when facing global financial pressures or seeking to promote domestic economic growth.