Creator: Bocola, Luigi and Lorenzoni, Guido Series: Staff report (Federal Reserve Bank of Minneapolis. Research Department) Number: 557 Abstract:
We study financial panics in a small open economy with floating exchange rates. In our model, bank runs trigger a decline in domestic wealth and a currency depreciation. Runs are more likely when banks have dollar debt. Dollar debt emerges endogenously in response to the precautionary motive of domestic savers: dollar savings provide insurance against crises; so when crises are possible it becomes relatively more expensive for banks to borrow in local currency, which gives them an incentive to issue dollar debt. This feedback between aggregate risk and savers’ behavior can generate multiple equilibria, with the bad equilibrium characterized by financial dollarization and the possibility of bank runs. A domestic lender of last resort can eliminate the bad equilibrium, but interventions need to be fiscally credible. Holding foreign currency reserves hedges the fiscal position of the government and enhances its credibility, thus improving financial stability.
Keyword: Lending of last resort, Dollarization, Financial crises, and Foreign reserves Subject (JEL): F34 - International Lending and Debt Problems, G11 - Portfolio Choice; Investment Decisions, E44 - Financial Markets and the Macroeconomy, and G15 - International Financial Markets
Creator: Arellano, Cristina and Heathcote, Jonathan Series: Staff report (Federal Reserve Bank of Minneapolis. Research Department) Number: 385 Abstract:
How does a country’s choice of exchange rate regime impact its ability to borrow from abroad? We build a small open economy model in which the government can potentially respond to shocks via domestic monetary policy and by international borrowing. We assume that debt repayment must be incentive compatible when the default punishment is equivalent to permanent exclusion from debt markets. We compare a floating regime to full dollarization.
We find that dollarization is potentially beneficial, even though it means the loss of the monetary instrument, precisely because this loss can strengthen incentives to maintain access to debt markets. Given stronger repayment incentives, more borrowing can be supported, and thus dollarization can increase international financial integration. This prediction of theory is consistent with the experiences of El Salvador and Ecuador, which recently dollarized, as well as with that of highly-indebted countries like Italy which adopted the Euro as part of Economic and Monetary Union: in each case, around the time of regime change, spreads on foreign currency government debt declined substantially.
Keyword: Debt policy, Borrowing limits, Exchange rate regime, and Dollarization Subject (JEL): E40 - Money and Interest Rates: General and F30 - International Finance: General
Creator: Chari, V. V. and Kehoe, Patrick J. Series: Staff report (Federal Reserve Bank of Minneapolis. Research Department) Number: 308 Abstract:
We analyze the setting of monetary and nonmonetary policies in monetary unions. We show that in these unions a time inconsistency problem in monetary policy leads to a novel type of free-rider problem in the setting of nonmonetary policies, such as labor market policy, fiscal policy, and bank regulation. The free-rider problem leads the union’s members to pursue lax nonmonetary policies that induce the monetary authority to generate high inflation. The free-rider problem can be mitigated by imposing constraints on the nonmonetary policies, like unionwide rules on labor market policy, debt constraints on members’ fiscal policy, and unionwide regulation of banks. When there is no time inconsistency problem, there is no free-rider problem, and constraints on nonmonetary policies are unnecessary and possibly harmful.
Keyword: Fixed exchange rates, Monetary regime, European Union, Dollarization, and Maastricht Treaty Subject (JEL): F42 - International Policy Coordination and Transmission, F41 - Open Economy Macroeconomics, E63 - Comparative or Joint Analysis of Fiscal and Monetary Policy; Stabilization; Treasury Policy, E58 - Central Banks and Their Policies, F30 - International Finance: General, F33 - International Monetary Arrangements and Institutions, E61 - Policy Objectives; Policy Designs and Consistency; Policy Coordination, and E42 - Monetary Systems; Standards; Regimes; Government and the Monetary System; Payment Systems