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Understanding Financial Vulnerability in Partially Dollarized Economies

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  • Diego Winkelried
  • Juan Francisco Castro
  • Eduardo Morón

Abstract

The reduction of macroeconomic vulnerability in emerging markets is now at the core of the research agenda. Liability dollarization plays a vital role in the understanding of vulnerability and its implications (from a general equilibrium perspective) have been addressed in the literature via the inclusion of a “financial accelerator†mechanism. In particular, its formalization is based on Bernanke’s, et al. (1998) optimal contract, which predicts a negative relation between an external finance premium and firm’s net worth. We can identify two channels by which the financial accelerator can be triggered. The first, emphasized in Bernanke, et al. (1998) and Gertler, et al. (2001), operates via shocks on asset prices which, in turn, affect the realized return on capital and net worth. The second channel, privileged in Céspedes, et al. (2000a y 2000b), depends on unanticipated movements in firm’s debt burden which directly affect their net worth. Not surprisingly, liability dollarization plays an important role in the activation of this second channel since the unexpected component of a real depreciation can greatly magnify the debt burden of firms if their debt is denominated in dollars. Based on this, Céspedes, et al. (2000a y 2000b) present a first approximation to a definition of vulnerability. In particular, an economy is classified as vulnerable if a real exchange rate depreciation implies an increase in the risk premium faced by firms. This result is neatly summarized in the log linear version of the risk premium equation and depends, crucially, on firms indebtness level. Their model, however, assumes complete depreciation and, thus, lacks the asset price channel explained above. Gertler, et al. (2001) recognize this issue and present some simulations using dollar denominated debt and an active asset price mechanism. Despite these significant contributions to the understanding of the consequences of liability dollarization for output fluctuations, we believe some important extensions are now in order: (i) if we want to address the implications of the degree of dollarization, we need a general equilibrium model that admits firm’s debt to be denominated in both local and foreign currency (the two models just described assume full liability dollarization); (ii) central bank’s response to exchange rate innovations (given a degree of dollarization) must be assessed from a welfare point of view; and (iii) given a dollarization level and central bank’s response to shocks, a new, encompassing, definition of vulnerability must be provided in order to adequately address the way in which it can be mitigated

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Bibliographic Info

Paper provided by Econometric Society in its series Econometric Society 2004 Latin American Meetings with number 260.

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Date of creation: 11 Aug 2004
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Handle: RePEc:ecm:latm04:260

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Keywords: Financial vulnerability; Dollarization; Monetary Policy;

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References

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  1. Erceg, Christopher J. & Henderson, Dale W. & Levin, Andrew T., 2000. "Optimal monetary policy with staggered wage and price contracts," Journal of Monetary Economics, Elsevier, vol. 46(2), pages 281-313, October.
  2. Mark Gertler & Simon Gilchrist & Fabio M. Natalucci, 2003. "External constraints on monetary policy and the financial accelerator," BIS Working Papers 139, Bank for International Settlements.
  3. Svensson, Lars E. O., 2000. "Open-economy inflation targeting," Journal of International Economics, Elsevier, vol. 50(1), pages 155-183, February.
  4. Marco Vega & Diego Winkelried, 2004. "How Does Global Disinflation Drag Inflation in Small Open Economies?," Macroeconomics 0403008, EconWPA.
  5. Eduardo Moron & Diego Winkelried, 2002. "Monetary Policy Rules for Financially Vulnerable EconomieEd," Macroeconomics 0205001, EconWPA.
  6. Eduardo Moron & Juan F. Castro, 2003. "Dedollarizing the Peruvian Economy," Macroeconomics 0312005, EconWPA.
  7. Klein, Paul, 2000. "Using the generalized Schur form to solve a multivariate linear rational expectations model," Journal of Economic Dynamics and Control, Elsevier, vol. 24(10), pages 1405-1423, September.
  8. Bernanke, Ben S. & Gertler, Mark & Gilchrist, Simon, 1999. "The financial accelerator in a quantitative business cycle framework," Handbook of Macroeconomics, in: J. B. Taylor & M. Woodford (ed.), Handbook of Macroeconomics, edition 1, volume 1, chapter 21, pages 1341-1393 Elsevier.
  9. Christian Broda & Eduardo Levy Yeyati, 2003. "Endogenous Deposit Dollarization," Business School Working Papers dieciseis, Universidad Torcuato Di Tella.
  10. Eduardo Levy Yeyati & Alain Ize, 1998. "Dollarization of Financial Intermediation," IMF Working Papers 98/28, International Monetary Fund.
  11. Luis Felipe Cespedes & Roberto Chang & Andres Velasco, 2000. "Balance Sheets and Exchange Rate Policy," NBER Working Papers 7840, National Bureau of Economic Research, Inc.
  12. Bernanke, Ben & Gertler, Mark, 1989. "Agency Costs, Net Worth, and Business Fluctuations," American Economic Review, American Economic Association, vol. 79(1), pages 14-31, March.
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