Abstract:
Credit contracts in developing countries are often denominated in foreign currencies, even after many of these economies succeeded in controlling inflation. This paper proposes a new interpretation of this apparent puzzle based on the demand for insurance against real aggregate shocks. The fact that devaluations occur more frequently in adverse states of the world provides a motive for holding dollar assets when the risk of recession is the main source
of volatility in consumption. This approach implies a complementarity between the optimal monetary policy and the currency denomination of contracts. When a large proportion of liabilities is denominated in a foreign currency, the optimal exchange rate volatility is low. This raises the vulnerability of the economy to aggregate shocks and reinforces the demand for dollar assets. Based on this complementarity, the model predicts persistence in the degree of “dollarization” in economies with low inflationary risk.
Credit contracts in developing countries are often denominated in foreign currencies, even after many of these economies succeeded in controlling inflation. This paper proposes a new interpretation of this apparent puzzle based on the demand for insurance against real aggregate shocks. The fact that devaluations occur more frequently in adverse states of the world provides a motive for holding dollar assets when the risk of recession is the main source
of volatility in consumption. This approach implies a complementarity between the optimal monetary policy and the currency denomination of contracts. When a large proportion of liabilities is denominated in a foreign currency, the optimal exchange rate volatility is low. This raises the vulnerability of the economy to aggregate shocks and reinforces the demand for dollar assets. Based on this complementarity, the model predicts persistence in the degree of “dollarization” in economies with low inflationary risk.
