Monetary Policy Effectiveness and Inflation Dynamics in a Dollarized Economy: Fresh insight from Laos

The paper critically analyses the monetary policy transmission in a dollarized economy in the Lao PDR. The results indicate that interest rate policies are ineffective in the management of inflation because of restrictions of a structural nature, such as a high level of currency substitution and poor financial market integration. The research proposes the need for financial institutions to focus on the development of their local market and strong financial intermediation before depending on the policy of the interest rate. When the relationship between money supply growth and inflation is positive, it suggests that tight management of money expansion is deserved, and growth can act as a curative measure against inflation. Yet supply-side bottlenecks persist, underlining the need for investment in infrastructure. The paper also finds that Laos' exposure to external price shocks there to its reliance on imports, recommending that the country pursue a strategy of foreign exchange reserve accumulation and import substitution. Moreover, the accumulation and adequacy of foreign reserves are important issues in macroeconomic stability. This study adds to global knowledge by showing how the dynamics of inflation in dollarized, developing countries are different than those in advanced economies, and “provides a model, which can apply to many other countries having the same features”. The paper offers specific policy options, such as financial de-dollarization, cautious monetary management, managing foreign reserves, and infrastructure development, to mitigate inflation and promote sustained economic growth.