Financial Frictions and the Interest-Rate Differential in a Dollarized Economy
This paper presents a partial equilibrium characterization of the credit market in an economy with partial financial dollarization. Financial frictions, in the form of costly state veri cation and banking regulation restrictions, are introduced and their impact on lending and deposit interest rates denominated in domestic and foreign currency studied. The analysis shows that reserve requirements act as a tax that leads banks to decrease deposit rates, while the wedge between foreign and domestic currency lending rates is decreasing in exchange rate volatility and increasing in the degree of correlation between entrepreneurs returns and the exchange rate.
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