Financial Crises, Dollarization, and Lending of Last Resort in Open Economies

Luigi Bocola, Guido Lorenzoni

NBER Working Paper No. 23984
Issued in November 2017, Revised in June 2018
NBER Program(s):Asset Pricing, Economic Fluctuations and Growth, International Finance and Macroeconomics, Monetary Economics

Foreign currency borrowing is perceived as a source of financial instability in emerging markets. We propose a theory where liability dollarization arises from an insurance motive of domestic savers. Because financial crises are associated with currency depreciations, savers are reluctant to hold assets denominated in local currency. This behavior makes local currency debt expensive, incentivizing borrowers to issue foreign currency debt. We show that this mechanism can generate multiple equilibria, with the bad equilibrium characterized by dollarization and financial instability. A domestic lender of last resort can eliminate the bad equilibrium, but interventions need to be fiscally credible. Holdings of foreign currency reserves hedge the fiscal position of the government and enhance its credibility, thus improving financial stability.

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Document Object Identifier (DOI): 10.3386/w23984

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