A model of liability dollarization and myopic governments

Adam Honig

International Economic Journal, 2006, vol. 20, issue 3, 343-355

Abstract: Liability dollarization of the domestic banking system represents a source of vulnerability for emerging market countries. The root cause is a lack of faith in the domestic currency, which ultimately stems from the belief that the government will not follow policies that promote long-run currency stability. This paper presents a model in which government myopia determines the unofficial dollarization of bank credit. Specifically, myopic politicians will choose low interest rates to expand short-run output in order to get re-elected, but this choice has the long-run consequence of increasing dollar lending. Increased liability dollarization is shown to force the hand of future decision-makers into choosing fixed exchange rates because of the fear that large depreciations will destroy balance sheets. The results imply that institutional reforms are necessary to reverse liability dollarization.

Keywords: Liability dollarization; government myopia (search for similar items in EconPapers)
Date: 2006
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Citations: View citations in EconPapers (2)

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DOI: 10.1080/10168730600879414

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