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Should government smooth exchange rate risk?

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  • Ilan Goldfajn

    ()
    (Department of Economics PUC-Rio)

  • Marcos Antonio Silveira

    ()
    (Department of Economics PUC-Rio)

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    Abstract

    A general equilibrium model is built to explain if there are circumstances in which exchange rate risk smoothing (ERRS) policies may bring a Pareto-improvement for a indebted small open (home) economy. The model shows that this is the case when overpessimistic foreign creditors demand a large spread on the default risk-free world interest rate, whose size can be reduced by ERRS policies and, in addition, market imperfections, such as information asymmetry between foreign investors and domestic debtors, prevent home economy’s residents from internalizing all benefits and costs of the exchange rate risk reallocation into their allocative decisions.

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    File URL: http://www.econ.puc-rio.br/pdf/td465.pdf
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    Bibliographic Info

    Paper provided by Department of Economics PUC-Rio (Brazil) in its series Textos para discussão with number 465.

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    Length: 38 pages
    Date of creation: Oct 2002
    Date of revision:
    Publication status: Published in the Journal of Development Economics v.69, n.2, p. 393-421, 2002
    Handle: RePEc:rio:texdis:465

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    1. Calvo, Guillermo A. & Mendoza, Enrique G., 2000. "Rational contagion and the globalization of securities markets," Journal of International Economics, Elsevier, vol. 51(1), pages 79-113, June.
    2. Sushil Bikhchandani & Sunil Sharma, 2001. "Herd Behavior in Financial Markets," IMF Staff Papers, Palgrave Macmillan, vol. 47(3), pages 1.
    3. David K. Backus & Patrick J. Kehoe, 1988. "On the denomination of government debt: a critique of the portfolio balance approach," Staff Report 116, Federal Reserve Bank of Minneapolis.
    4. Bohn, Henning, 1990. "Tax Smoothing with Financial Instruments," American Economic Review, American Economic Association, vol. 80(5), pages 1217-30, December.
    5. Enrique G. Mendoza & Guillermo A. Calvo, 2000. "Capital-Markets Crises and Economic Collapse in Emerging Markets: An Informational-Frictions Approach," American Economic Review, American Economic Association, vol. 90(2), pages 59-64, May.
    6. Guillermo A. Calvo & Enrique G. Mendoza, 1996. "Mexico's balance-of-payments crisis: a chronicle of death foretold," International Finance Discussion Papers 545, Board of Governors of the Federal Reserve System (U.S.).
    7. Torsten Persson & Lars E.O. Svensson, 1983. "Is Optimism Good in a Keynesian Economy?," NBER Working Papers 1071, National Bureau of Economic Research, Inc.
    8. Missale, Alessandro, 1997. " Managing the Public Debt: The Optimal Taxation Approach," Journal of Economic Surveys, Wiley Blackwell, vol. 11(3), pages 235-65, September.
    9. Ilan Goldfajn, 1998. "Public Debt Indexation and Denomination: The Case of Brazil," Working Papers Central Bank of Chile 27, Central Bank of Chile.
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