unit of account in some transactions. i. full dollarization during the 1990s many economies were struggling to control or stabilize inflation. many of them had used a pegged exchange rate to bring inflation down from triple digit levels. it was then that the power of the impossible trinity – of the combination of a pegged exchange rate, free capital movements, and a monetary policy dedicated to domestic goals – became clear, and that a series of financial crises erupted. further, as the financial crises of that decade unfolded, it also became evident that the impossible trinity should be amended to say that the combination of a pegged exchange rate, free capital movements, and macroeconomic policy – not just monetary policy – dedicated to domestic goals was not possible. the resultant trilemma pointed in three possible directions : one was to attempt to control international capital flows, a solution that for good reasons was rejected by most countries 1 ; the second was to move to a more flexible exchange rate – though not necessarily one that was totally free - floating ; and the third was to strengthen the exchange rate peg, either by adopting a currency board, or by getting rid of the exchange rate entirely, that is by adopting a foreign currency, or full dollarization. the major benefit of the third solution as seen at the time – and as emphasized particularly by my then - colleague michael deppler of the imf – was that a country that adopted that solution would among these reasons is that capital controls tend to : cut the development of the financial sector of the country off from the global economy ; cut the economy off from the benefits of international trade in assets ; and are frequently ineffective and a source of corruption. however, countries with capital controls, a weak macroeconomic framework, and a vulnerable financial system, need to strengthen the macroeconomic system and the financial system before or as they liberalize. rapidly see the benefits of the enhanced credibility of monetary policy in lower interest rates. when one considers for instance the case of turkey, where high real interest rates in the late 1990s and in the run - up to the crisis created a massive fiscal problem 2, the benefits of the lower interest rates were obvious. those benefits had been seen in the case of bulgaria when it adopted a currency board solution, a step just short of full dollarization, and they were seen also in the full dollarization cases of el salvador and ecuador in the early years of this decade. they were seen too in the cases of the countries joining, or slated to join, the

there may be some leeway between foreign and domestic interest rates, giving monetary policy some leverage. although i have not so far distinguished between dollarization and exchange - rate linking of assets and liabilities, there is a potentially important difference. so long as assets and liabilities are exchange - rate linked, and payable only in the domestic currency, the central bank still technically has the capacity to serve as lender of last resort in the domestic currency, even without holding massive reserves. but this the literature uses the concept of a minimum variance portfolio for the economy, which includes a significant share of foreign - currency or foreign - currency denominated assets. does mean that the impact on the exchange rate of a significant financial crisis is likely to be very large in an economy with extensive dollarization. empirical work shows that monetary policy in heavily dollarized economies tends to aim to smooth the exchange rate. this is not surprising given that economic agents in such an economy are very vulnerable to exchange rate changes, and that monetary - policy makers will typically also be concerned about the stability of the financial system. in that regard, it is often suggested, and correctly, that reserve requirements against foreign currency liabilities should be larger than those against domestic currency liabilities, and that especial care needs to be taken in evaluating the risks associated with foreign currency assets. however, it is also the case that the more difficult it becomes to hold foreign - currency assets in the domestic banking system, the more those assets are likely to be held outside the banking system, quite possibly abroad – in other words, actions to limit the extent of dollarization may well contribute to capital flight. why not simply fix the exchange rate? we have already discussed that issue, under the heading of full dollarization. it can be done, for small economies, and for ones – such as the candidates for entry into emu – that know how they will ultimately exit the fixed exchange rate arrangement. but it is also a dangerous course of action for those countries that might one day find themselves having to change the exchange rate. there is some evidence that the provision of price - indexed financial assets helps reduce the extent of dollarization. that makes considerable sense, since the underlying issue for asset - holders is increasing the safety of their portfolios. generally countries that suffer from high inflation, which empirically means also unstable inflation, provide a range of assets, including both price - and foreignexchange indexed assets. but extensive price level indexation, like dollar