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A model of liability dollarization and myopic governments

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  • Adam Honig

Abstract

Liability dollarization of the domestic banking system represents a source of vulnerability for emerging market countries. The root cause is a lack of faith in the domestic currency, which ultimately stems from the belief that the government will not follow policies that promote long-run currency stability. This paper presents a model in which government myopia determines the unofficial dollarization of bank credit. Specifically, myopic politicians will choose low interest rates to expand short-run output in order to get re-elected, but this choice has the long-run consequence of increasing dollar lending. Increased liability dollarization is shown to force the hand of future decision-makers into choosing fixed exchange rates because of the fear that large depreciations will destroy balance sheets. The results imply that institutional reforms are necessary to reverse liability dollarization.

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File URL: http://www.tandfonline.com/doi/abs/10.1080/10168730600879414
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Bibliographic Info

Article provided by Taylor & Francis Journals in its journal International Economic Journal.

Volume (Year): 20 (2006)
Issue (Month): 3 ()
Pages: 343-355

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Handle: RePEc:taf:intecj:v:20:y:2006:i:3:p:343-355

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Related research

Keywords: Liability dollarization; government myopia;

References

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  1. Olivier Jeanne, 2003. "Why Do Emerging Economies Borrow in Foreign Currency?," IMF Working Papers 03/177, International Monetary Fund.
  2. Mishkin, Frederic S. & Savastano, Miguel A., 2001. "Monetary policy strategies for Latin America," Policy Research Working Paper Series 2685, The World Bank.
  3. Ricardo Hausmann & Ugo Panizza & Ernesto H. Stein, 2000. "Why Do Countries Float the Way They Float?," IDB Publications 6467, Inter-American Development Bank.
  4. Aghion, Philippe & Bacchetta, Philippe & Banerjee, Abhijit, 2000. "A simple model of monetary policy and currency crises," European Economic Review, Elsevier, vol. 44(4-6), pages 728-738, May.
  5. Acemoglu, Daron & Johnson, Simon & Robinson, James A & Thaicharoen, Yunyong, 2002. "Institutional Causes, Macroeconomic Symptoms: Volatility, Crises and Growth," CEPR Discussion Papers 3575, C.E.P.R. Discussion Papers.
  6. Hoyt Bleakley & Kevin Cowan, 2005. "Corporate Dollar Debt and Depreciations: Much Ado About Nothing?," Research Department Publications 4411, Inter-American Development Bank, Research Department.
  7. Barry Eichengreen & Ricardo Hausmann, 1999. "Exchange rates and financial fragility," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, pages 329-368.
  8. De Nicolo, Gianni & Honohan, Patrick & Ize, Alain, 2003. "Dollarization of the banking system : good or bad?," Policy Research Working Paper Series 3116, The World Bank.
  9. John D. Burger & Francis E. Warnock, 2003. "Diversification, original sin, and international bond portfolios," International Finance Discussion Papers 755, Board of Governors of the Federal Reserve System (U.S.).
  10. Ize, Alain & Yeyati, Eduardo Levy, 2003. "Financial dollarization," Journal of International Economics, Elsevier, vol. 59(2), pages 323-347, March.
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