Financial Crises, Dollarization and Lending of Last Resort in Open Economies
- American Economic Review (Forthcoming)
Foreign currency debt is perceived as a source of financial instability in emerging markets. We propose a theory in which liability
dollarization arises from an insurance motive of domestic savers.
Since financial crises are associated to depreciations, savers ask for
a risk premium when saving in local currency. This force makes
domestic currency debt expensive, and incentivizes borrowers to issue foreign currency debt. Providing ex-post support to borrowers
can alleviate the effect of the crisis on savers' income, lowering
their demand for insurance, and, surprisingly, it can reduce ex-
ante incentives to borrow in foreign currency.
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