Financial Dollarization and Central Bank Credibility
Why do firms and banks hold foreign currency denominated liabilities? The authors argue that foreign currency debt, by altering the effect of a devaluation on output, has a disciplining effect when the Central Bank's objectives differ from the...
| Main Authors: | , |
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| Format: | Policy Research Working Paper |
| Language: | English en_US |
| Published: |
World Bank, Washington, DC
2014
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| Subjects: | |
| Online Access: | http://documents.worldbank.org/curated/en/2003/06/2438507/financial-dollarization-central-bank-credibility http://hdl.handle.net/10986/18170 |
| Summary: | Why do firms and banks hold foreign
currency denominated liabilities? The authors argue that
foreign currency debt, by altering the effect of a
devaluation on output, has a disciplining effect when the
Central Bank's objectives differ from the social
optimum. However, under imperfect information, bad priors
about the Central Bank induce excess dollarization of
liabilities, which in turn limits the ability of the Central
Bank to conduct an optimal monetary policy. In addition the
economy may become stuck in a "dollarization trap"
in which dollarized liabilities limit the ability of agents
to learn the true type of the monetary authority. The model
has clear-cut policy implications regarding the taxation of
foreign currency liabilities as a way to encourage perfect
information and avoid dollarization traps. Moreover, it
reinforces the existing argument for Central Bank
independence. Finally, the authors believe this model to be
consistent with a growing empirical literature on the
determinants of foreign currency liabilities and their
relationships to Central Bank credibility. |
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