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Title: |
A Model of Liability Dollarization and Myopic Government |
| Author: |
Honig, Adam |
| Author
Affiliation: |
Amherst College, USA |
| Source: |
International Economic Journal, September 2006, v. 20, no. 3, pp. 343-356 |
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Publication Date: |
September 2006 |
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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. |
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