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Financial Instability under a Flexible Exchange Rate


  • Damien Besancenot
  • Radu Vranceanu


Many governments in developing countries contemplate the possibility of increasing the flexibility of their exchange rates despite having accumulated substantial dollar-denominated debt. Using a model of corporate dollar debt in which the future exchange rate is uncertain, this paper studies the financial risks that might arise as a consequence of increased exchange rate flexibility. Since a firm may default on its debt either because its dollar income is too low or because investors refuse to roll over its debt, the measure of the overall risk of default should take into account both factors, as well as their interaction. Solving the model for the no-default rational expectations equilibrium, we find that a small risk of insolvency may bring about a substantial risk of illiquidity. Copyright The editors of the "Scandinavian Journal of Economics" 2007 .

Suggested Citation

  • Damien Besancenot & Radu Vranceanu, 2007. "Financial Instability under a Flexible Exchange Rate," Scandinavian Journal of Economics, Wiley Blackwell, vol. 109(2), pages 291-302, June.
  • Handle: RePEc:bla:scandj:v:109:y:2007:i:2:p:291-302

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    References listed on IDEAS

    1. Kenneth Rogoff, 1999. "International Institutions for Reducing Global Financial Instability," Journal of Economic Perspectives, American Economic Association, vol. 13(4), pages 21-42, Fall.
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    Cited by:

    1. Besancenot, Damien & Vranceanu, Radu, 2014. "Experimental evidence on the ‘insidious’ illiquidity risk," Research in Economics, Elsevier, vol. 68(4), pages 315-323.
    2. Virtue Ekhosuehi & Sunday Ogbonmwan, 2014. "Determination of the optimal exchange rate via control of the domestic interest rate in Nigeria," Operations Research and Decisions, Wroclaw University of Technology, Institute of Organization and Management, vol. 1, pages 23-36.

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