Institutional quality, financial development, and dollarization: A Bayesian analysis of interaction and threshold effects

Abstract

This paper examines how financial development across three dimensions, financial depth, financial access, and financial stability, shapes dollarization, with a particular focus on the moderating role of institutional quality. It further explores the nonlinear relationship between financial development and dollarization across countries. This paper employs a Bayesian regression approach to estimate interaction and threshold effects in the research models, allowing for full probabilistic inference regarding parameter uncertainty. To address the linear moderating effects of institutional quality, a baseline model incorporating interaction terms between institutional quality and each financial development dimension is adopted. Furthermore, a threshold model is adopted to explore potential nonlinear and regime-dependent effects of institutional quality. The research results show that financial development can generally lead to a decrease in dollarization, but this effect depends on institutional quality across countries. The interaction terms between financial depth and institutional quality indicate that stronger institutional environments can amplify the effect of financial development in reducing dollarization. Moreover, financial depth and financial access exhibit strong threshold effects at high levels of institutional quality across different countries. A notable finding is the surprising positive effect of financial stability (BANKZ) on dollarization across both institutional quality groups. Financial stability exhibits no statistically significant threshold dependence and remains stable across regimes.