Currency Choices in Contracts

Andres Drenik, Diego Perez and Rishabh Kirpalani
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Andres Drenik: Columbia University
Diego Perez: New York University
Rishabh Kirpalani: The Pennsylvania State University

No 832, 2018 Meeting Papers from Society for Economic Dynamics

Abstract: We study the optimal currency choice in contracts in an economy with credit chains and endogenous government-policy risk. Denominating contracts in local currency helps mitigate real exchange rate risk while denominating in a foreign currency (dollar) minimizes risks due to government policy, for example inflation. In the aggregate, the equilibrium currency denomination calls for a coordination of currencies in bilateral contracts within a chain to avoid costly default due to currency mismatch. This implies that the incentives to denominate in a foreign currency might persist even after government/political risk has been significantly reduced. Our model can help explain the observed hysteresis of dollarization that occurred in several Latin American countries. We also show that the socially optimal allocation would call for even more dollarization than is privately optimal in order to constrain the government’s choices ex-post.

Date: 2018
New Economics Papers: this item is included in nep-mon and nep-opm
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Persistent link: https://EconPapers.repec.org/RePEc:red:sed018:832

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