JOURNAL OF ECONOMIC DEVELOPMENT 99 Volume 38, Number 2, June 2013 DOES DOLLARIZATION ALLEVIATE OR AGGRAVATE EXCHANGE RATE VOLATILITY? LULA G. MENGESHA a AND MARK J. HOLMES b * a,b University of Waikato, New Zealand 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. Keywords: Dollarization, Exchange Rate Volatility, Eritrea, Official and Black Market JEL classification: F3, O2, O5 1. INTRODUCTION The dollarization of the developing countries has been an inspiring field of research for many scholars. Despite a number of studies that address the measurement and consequences of dollarization, this literature concentrates on the Latin American and Asian economies with very limited focus on African economies. In this paper, we investigate whether dollarization alleviates or aggravates exchange rate volatility in the case of Eritrea. The existing literature suggests that the impact of dollarization can depend on the form of dollarization that exists in a given economy. For example, Akofio-Sowah (2009), Savvides (1996), Schnabl, (2007) and Barrell et al. (2009) among * We are most grateful for the helpful comments provided by the Editor and an anonymous referee. We are also grateful for comments provided at the 9th Biennial Pacific Rim Conference of the Western Economic Association International held at Queensland University of Technology in April 2011. The usual disclaimer applies.