Financial Crises, Dollarization, and Lending of Last Resort in Open Economies
Foreign currency borrowing is perceived as a source of financial instability in emerging markets. We propose a theory where liability dollarization arises from an insurance motive of domestic savers. Because financial crises are associated with currency depreciations, savers are reluctant to hold assets denominated in local currency. This behavior makes local currency debt expensive, incentivizing borrowers to issue foreign currency debt. We show that this mechanism can generate multiple equilibria, with the bad equilibrium characterized by dollarization and financial instability. A domestic lender of last resort can eliminate the bad equilibrium, but interventions need to be fiscally credible. Holdings of foreign currency reserves hedge the fiscal position of the government and enhance its credibility, thus improving financial stability.
Published Versions
Luigi Bocola & Guido Lorenzoni, 2020. "Financial Crises, Dollarization, and Lending of Last Resort in Open Economies," American Economic Review, vol 110(8), pages 2524-2557. citation courtesy of 
Related
Topics
More from NBER
In addition to working papers, the NBER disseminates affiliates’ latest findings through a range of free periodicals — the NBER Reporter, the NBER Digest, the Bulletin on Retirement and Disability, the Bulletin on Health, and the Bulletin on Entrepreneurship — as well as online conference reports, video lectures, and interviews.
