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

Luigi Bocola and Guido Lorenzoni ()

No 23984, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: 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.

JEL-codes: E44 F34 F41 G11 G15 (search for similar items in EconPapers)
Date: 2017-11
New Economics Papers: this item is included in nep-dge, nep-mac, nep-mon and nep-opm
Note: AP EFG IFM ME
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Citations: View citations in EconPapers (20)

Published as Luigi Bocola & Guido Lorenzoni, 2020. "Financial Crises, Dollarization, and Lending of Last Resort in Open Economies," American Economic Review, vol 110(8), pages 2524-2557.

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Journal Article: Financial Crises, Dollarization, and Lending of Last Resort in Open Economies (2020)
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