1. Behavior of Inflation Volatility in El Salvador
under a dollarization regime
Rafael Mata León*†
Abstract
Complete Dollarization occurs when the inhabitants of a country use the
United States dollar instead of the domestic currency. Under this regime,
domestic nominal interest rate is pegged to the US nominal interest rate. At
present time, three countries have adopted this monetary policy strategy,
Ecuador, El Salvador, and Panama, in the years 2000, 2001, and 1904
respectively. Dollarization, as Reinhart et al mention, is increasingly a defining
characteristic in many emerging market economies. There are very few
observed cases of dollarization, and hence history provides little guidance as to
its consequences.
The purpose of this study is to observe and compare the inflation volatility of
El Salvador related to the fluctuations in the same index of the United States.
As we will observe, there was a cointegration of series between El Salvador and
the US inflation before the US dollar was adopted in 2001 as the main currency.
The methodology to follow is to gather monthly data from 1996 to 2010, and
work with the logarithm percent change. The data will be obtained from different
sources such as central banks, IMF, ecowin Reuters, etc.
We will observe how the adoption of the US dollar in El Salvador helped to
control the volatility of inflation. Consequently, better and more secure
information became available. Now, the volatility of inflation follows a pattern
that can be studied and this is a necessary condition to attract foreign direct
investment to the country. Also, we will observe that the existence of volatility of
inflation in El Salvador is mainly due to a variance in the consumer prices of non
transactable goods.
Advisor: Antonio Moreno Ibañez
*Department of Economics, Universidad de Navarra, Pamplona, Spain. E-mail : rmleon@alumni.unav.es
† I would like to thank Carlos Carcach because he showed me the path to be followed. To my advisor
Antonio Moreno for all the help and guidance provided. To my director and all my professors of the
master, because they taught me the few things I know about economics. Finally special thanks to my
parents, family, and friends who were constantly supporting me.

2. Content Page
1. Introduction 2
1.1. El Salvador 3
2. Model 6
3. Data 6
4. Results 7
5. Conclusion 9
6. Tables and Figure 11
2

3.  Introduction
Dollarization is the process by which a country leaves its own currency and
adopts a more stable currency as its main legal currency. When a country takes
the decision to dollarize it adopts the monetary policy of the Federal Reserve of
the United States with the objective of have more stable cycles of devaluation
and inflation. To use the US dollar drastically reduces the exchange and market
risk, it reduces transaction costs for goods and services in the international
environment, and it is easier to accountability evolved in the international ambit.
The supposedly reduction in the nominal interest rate will attract more foreign
direct investment and consequently growth.
On the other hand the welfare costs of dollarization, relative to the optimal
policy, are due to both the fixity of exchange rates and the loss of seigniorage.
Seigniorage is the difference between the value of money and the cost to
produce it, or in other words, the economic cost of producing a currency within a
given economy or country. If the seigniorage is positive, then the government
will make an economic profit; a negative seigniorage will result in an economic
loss. For example, if to a central bank the cost of produce a bill of one monetary
unit is 0.05 monetary units, the positive seigniorage resulting of 0.95 monetary
units. The measured dollar loss of seigniorage may be associated with an
increase in social welfare. The implication is that computed seigniorage losses
can only be unambiguously interpreted as “real losses” to the economy if policy
credibility problems are assumed away, a point that seems to have been
missed in the debate.
The fixity of the exchange rate eliminates the faculty of using the real
exchange rate to avoid or reduce external shocks, and even the political
instability typical from our countries.
To adopt a dollarization strategy does not guarantee the economic growth
and stability. Have volatility of inflation been reduced with the adoption if the US
as the main currency in El Salvador?
3

4. o El Salvador
At the end of November 2000 the Salvadorian government approves the
Monetary Integration Law. On January 1st 2001 all ATM’s were programmed to
give dollars and all saving accounts were converted to the US currency. The
way to proceed is to peg a rate to debts, contracts, and financial assets. When
a country pegs its currency against another one, its inflation rate must converge
towards the inflation rate of this foreign partner because of the risk of losing
competitiveness and current account imbalances.1 Additional perceived
advantages of pegging the exchange rate include the potential reduction of the
devaluation risk and the default or sovereign risk (default or sovereign risk is the
possibility that a country will default on its external debt) of domestic interest
rates, thereby lowering the cost of borrowing for both the government and the
private sector and encouraging greater international trade.2
The decision to adopt the US dollar as the main currency is still in debate to
some economists. As we will observe, the inflation in El Salvador at the moment
it dollarized was already below the media by year 1999 (see Figure 1). The
inflation since 1999 began to follow a similar path as the US. By the year the
law was passed El Salvador’s inflation behave most likely to the US inflation,
with the exception that the “shocks” seems to affect more El Salvador. In figure
2 we can observe how after the US dollar was adopted as the main currency
the distance between the media is still the same as we can observe in figure 3.
The intention of this paper is to try to explain the reason why the distance
between the media is still the same.
The Universidad Centroamericana (UCA) analyzed the economic situation of
El Salvador during 2007 and they found out that 50.3% of Salvadorians
consider that dollarization is the responsible for the increase in the cost of life.
On the other hand, the next day the US dollar became the official currency rate,
1
Hoarau, Jean-François; Blancard, Stéphane; and Jean-Pierre Phillipe. Testing for nominal convergence
in the Central America area : evidence from panel data unit-root tests. Applied Economics Letters,
16:11, 1171 – 1174 (2009).
2
Hoarau, Jean-François; Blancard, Stéphane; and Jean-Pierre Phillipe. Testing for nominal convergence
in the Central America area : evidence from panel data unit-root tests. Applied Economics Letters,
16:11, 1171 – 1174 (2009).
4

5. the interest rate to lend money to consumption and mortgages fell from 17% to
11%.3
We will observe that the Salvadorian belief about the dollarization increasing
the cost of living is in reality that the prices of non-transactable goods have
been constantly increasing. Non-transactable are those that can only be
consumed in the economy they are produced; they can not be imported or
exported. In other words El Salvador has an “internal inflation” that if removed
from the calculation of the CPI we will observe how inflation is practically similar
to the US inflation. In this matter what the authorities in El Salvador should be
doing is to apply policies that are intentioned to control this internal inflation and
finally achieve the objective of removing the volatility of inflation in El Salvador.
In summary, the reasons why El Salvador adopted this monetary policy
strategy was because at that moment, it seemed to be the faster way to enter
into the globalization race, a fast technique to leave behind the poverty, and to
open itself to the world. It was a time that coffee, sugar, and cotton, the principal
goods that maintained the economy during the 90’s went down. The economy
needed a reengineering and the manufactured goods came to play. When the
law was approved, the intention was to create a high aggregated value of the
manufactured goods. Since El Salvador is a very small country, with very little
they could achieve what China has done until now, the problem was the world
crisis that appeared. We can say that the dollarization was the logical step to
follow same as when a man marries a woman after years of dating. After all the
peg of 8.75 colones for 1 US dollar was done years before the law was passed.
3
Tyler Maroney, Dolarización: Iniciativa para el Diálogo Político, International Journalists’ Network
5

6.  Model
The way to proceed is to perform an ADF test to check for unit roots. As we
will prove, the inflation has a unit root and therefore is non-stationary. On the
other hand by performing the unit root test in 1st difference we will observe how
the series becomes stationary.
When all the variables are integrated of the same order, the second step is
to estimate the model, also called a "cointegrating equation," and test whether
the residual of the model is stationary.
The next step is to prove that the inflation is stationary if we eliminate the
non-transactable goods. Take a look for instance a figure 4. The inflation is
almost stationary when we leave out energy. In El Salvador we will show how
by applying a unit root test it is stationary at level difference.
The last step is to show if there is cointegration between El Salvador and US
inflation, even before the dollarization came into play. For this we will apply a
Johansen Cointegration Test and this will prove that the dollarization was the
logical step to follow. This will also explain why the distance between the media
of inflation is still the same even after the US dollar was adopted as the main
currency. The purpose of the cointegration test is to determine whether groups
of non-stationary series are cointegrated or not. EViews implements VAR-based
cointegration tests using the methodology developed in Johansen (1991, 1995).
 Data
The data we will be working with consist of 175 variables corresponding to
the monthly inflation from January 1996 to July 2010. The data is obtained
from Reuters EcoWin where the logarithmic percent change between each time
period is applied. The data for the calculation of inflation in El Salvador by
groups is the logarithm percent change and was obtained from El Salvador’s
central bank. 4
4
FuenteDirección General de Estadística y Censos (DIGESTYC)
6

7.  Results
When you are estimating a model that includes time series variables, the
first thing you need to make sure is that either all time series variables in the
model are stationary or they are cointegrated, which means that they are
integrated of the same order and errors are stationary, in which case the model
defines a long run equilibrium relationship among the cointegrated variables.
Therefore, a cointegration test generally takes two steps. The first step is to
conduct a unit root test on each variable to find the order of integration. In this
exercise the unit test root will be perform through an Augmented Dickey-Fuller
Test. As we will observe some variables are non-stationary then we will have to
perform a first difference in order to fix the problem of stationarity.
The ADF statistic value is -2.540701 and the associated one-sided p-value
is 0.1077. In addition, EViews reports the critical values at the 1%, 5% and 10%
levels. Notice here that the t-statistic value is greater than the critical values so
that we do not reject the null at conventional test sizes.
As we can observe, all the ADF statistic value is higher than the respective
critical values at all levels. Then we do not reject the null hypothesis so we say
that the time series variables are non-stationary (see table 1). We must do
differences of first or second degree until we are able to find stationarity (see
table 2).
As we observe in the tables by running the ADF test using the first difference
for each variable the ADF test statistic is smaller than the critical values at all
levels. Then we can say that the variables were integrated of first order.
Engle and Granger (1987) pointed out that a linear combination of two or
more non-stationary series may be stationary. If such a stationary linear
combination exists, the non-stationary time series are said to be cointegrated.
The stationary linear combination is called the cointegrating equation and may
be interpreted as a long-run equilibrium relationship among the variables.
7

8. The purpose of the cointegration test is to determine whether groups of non-
stationary series are cointegrated or not. EViews implements VAR-based
cointegration tests using the methodology developed in Johansen (1991, 1995).
As we can observe in table 3, the first block reports the so-called trace
statistics and the second block reports the maximum eigenvalue statistics. For
each block, the first column is the number of cointegrating relations under the
null hypothesis. In our case we do not reject the null hypothesis that the series
are cointegrated. Both, trace test indicates 1 cointegrating eqn(s) at the 0.05
level and Max-eigenvalue test indicates 1 cointegrating eqn(s) at the 0.05 level.
8

9.  Conclusion
The adoption of the US dollar as the main currency in El Salvador was a
measure proposed by the executive power and approved by the legislation in
less than 10 days. Historically the country has a trajectory of economic stability
interrupted only during the 80s by a social crisis that ended up in a civil war.
Nevertheless when in 1992 the peace agreements were signed, the economy
has enjoyed economic and financial stability. In other words, the dollarization
was presented as a way to participate in the globalization race, leaving back
poverty and was not imposed by market “forces”.
As we can observe, there existed a cointegration between the inflation of El
Salvador and the US. In fact, the exchange rate has been pegged for about 7
years before the monetary integration law was passed. The dollarization was a
way to “take the next step”. The economic cycles of El Salvador and the United
States are pretty much the same. As every inflation index, stationality is very
similar in both countries. The cointegration that existed before the law was
passed led to both inflations to behave similarly. When in January 2001 the US
becomes the official currency, one of the consequences was the supposedly
reduction in the volatility of inflation for El Salvador and consequently, the
reduction in distance between the media of inflation for El Salvador and the US,
nevertheless by observing figure 3 and 4 we can see how the distance
continues to be the same. Then we can say the there has not been a structural
change in the behavior of the volatility of inflation for El Salvador.
The reduction in volatility is a necessary condition to attract more foreign
direct investment and more secure and valid information in order to make
previsions and therefore plans. In figure 4 we can observe how the behavior of
the inflation in the US without taking into account the energy leads to almost a
complete stationary series. In El Salvador something similar happens. In figure
5 we can observe the behavior of inflation by groups in El Salvador. The groups
consist of:
9

10. 1 Food and non-alcoholic beverages 7 Transportation
2 Alcoholic beverages, tobacco, and
8 Communications
stupefacient
3 Clothing 9 Recreation and Culture
4 Shelter, water, electricity, gas, and other fuels 10 Education
5 Furniture, articles for the home and ordinary
11 Restaurants and Hotels
conservation of the home
6 Health 12 Diverse Services
As we can observe in the graph, since the US was adopted in 2001, the
goods that have increase the most in a year have been twice: transportation,
communications and education. While alcoholic beverages, tobacco, and
stupefacient; shelter, water, electricity, gas, and other fuels; and furniture,
articles for the home and ordinary conservation of the home have increased at
the most once. This means that El Salvador in order to have an almost perfect
stationary series will need to take out the non-transactable goods in the
calculation of the CPI. In other words, since dollarization appeared El Salvador
has encountered itself with an “internal inflation” due to the increase in prices of
non-transactable goods. It could be that the exchange of “colones” to US dollars
is the guilty of this increase in prices, but is a fact that the common feeling of
Salvadorians have about the increase in the cost of living comes from the fact
that non-transactable goods are more expensive than before. This is why the
distance of media between El Salvador and US inflation is the same, because in
some things dollarization has actually helped to reduce the uncertainty and
therefore the volatility while it has created an internal inflation.
It is still early to conclude if dollarization is good or bad. As mentioned
before, dollarization is something new and it is very few things we know about it.
What we can say for sure is that during the actual crisis, El Salvador has
suffered more than others because of the lack of its monetary tool. The lost of
seigniorage is an important loss of income to El Salvador’s central bank and the
FED is not willing to share the revenues. Volatility of transactable goods has
been reduced while an internal inflation of non-transactable goods has
appeared; which is very harmful to local industry. The information made to do
previsions is now better and more secure. Finally, foreign direct investment has
been constantly increasing since El Salvador became dollarized.
10

11.  Tables and Figure
Figure 1. Consumer Price Index of El Salvador and the United States
Consumer Price Index
30
27
24
21
18
15
12
9
6
3
0
19 07
19 01
19 01
20 7
20 07
20 01
20 01
20 01
20 7
20 07
20 1
19 1
19 01
19 07
19 7
20 07
20 01
20 01
20 1
20 07
20 1
20 07
20 07
20 7
20 7
20 01
20 01
20 1
20 07
7
/0
/0
/0
/0
/0
/0
/0
/0
/0
/0
/0
/
/
/
/
/
/
/
/
/
/
/
/
/
/
/
/
/
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/
96
98
99
01
05
06
07
08
96
97
97
98
99
00
00
01
02
02
03
03
04
04
05
06
07
08
09
09
10
10
19
SV [log 12 months] USA [log 12 months] SV Media [12.167795] USA Media [7.60054778]
Figure 2. Consumer Price Index of El Salvador and the United States after monetary integration law was passed
11

12. Figure 3. Consumer Price Index of El Salvador and the United States before monetary integration law was passed
Figure 4. Consumer Price Index of the United States, total and without energy
12

13. Figure 5. Consumer Price Index of El Salvador by groups
0.7
0.65
0.6
0.55
0.5
0.45
0.4
0.35
0.3
0.25
0.2
0.15
0.1
0.05
0
-0.05 2001 2002 2003 2004 2005 2006 2007 2008 2009
-0.1
-0.15
-0.2
-0.25
-0.3
-0.35
1.1 Alimentos y Bebidas no Alcohólicas 1.2 Bebidas Alcohólicas, Tabaco y Estupefacientes
1.3 Prendas de Vestir y Calzado 1.4 Alojamiento, Agua, Electricidad, Gas y Otros Combustibles
1.5 Muebles, Artículos para el Hogar y para la Conservación Ordinaria del Hogar 1.6 Salud
1.7 Transporte 1.8 Comunicaciones
1.9 Recreación y Cultura 1.10 Educación
1.11 Restaurantes y Hoteles 1.12 Bienes y Servicios Diversos
13

14. Table 1. Unit test root in level difference for using ADF for El Salvador’s inflation
14

15. Table 2. Unit test root in first difference for using ADF for El Salvador’s inflation
15

16. Table 3. Johansen Cointegration Test for inflation in El Salvador and the United States
Date: 09/01/10 Time: 02:53
Sample (adjusted): 2 175
Included observations: 174 after adjustments
Trend assumption: Linear deterministic trend
Series: SV_CPI USA_CPI
Lags interval (in first differences): No lags
Unrestricted Cointegration Rank Test (Trace)
Hypothesized Trace 0.05
No. of CE(s) Eigenvalue Statistic Critical Value Prob.**
None * 0.088868 18.25844 15.49471 0.0187
At most 1 0.011796 2.064683 3.841466 0.1507
Trace test indicates 1 cointegrating eqn(s) at the 0.05 level
* denotes rejection of the hypothesis at the 0.05 level
**MacKinnon-Haug-Michelis (1999) p-values
Unrestricted Cointegration Rank Test (Maximum Eigenvalue)
Hypothesized Max-Eigen 0.05
No. of CE(s) Eigenvalue Statistic Critical Value Prob.**
None * 0.088868 16.19375 14.26460 0.0245
At most 1 0.011796 2.064683 3.841466 0.1507
Max-eigenvalue test indicates 1 cointegrating eqn(s) at the 0.05 level
* denotes rejection of the hypothesis at the 0.05 level
**MacKinnon-Haug-Michelis (1999) p-values
16