On Liability Dollarization: A Simple Model with Domestic and Foreign Creditors
This paper presents a simple model of debt contracts in order to analyze the conditions under which domestic residents would choose to currency denomination of debt. In the model, borrowers are producers of non-traded goods and subject to real exchange rate shocks, that constitute the source of real shocks in the model. There is a domestic unit of account; prices in terms of that unit can be shocked by a (presumably policy-induced) disturbance. Debt obligations can be denominated in either traded goods (dollarized contracts) or local currency. When real and nominal shocks are possitively correlated, dollarized contracts tend to be preferable to (non-contingent) nominal contracts when nominal shocks are large and real shocks are small. When foreign risk-neutral investors are added to the model, we show that in equilibrium all domestic lenders invest their funds in (riskfree) foreign investment opportunities, and so local borrowers must fund their projects from the foreign lenders.
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|Date of revision:||Feb 2005|
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