# Positive and Normative Implications of Liability Dollarization for Sudden Stops Models of Macroprudential Policy

- 30 Downloads

## Abstract

“Liability dollarization,” namely intermediation of capital inflows in units of tradables into domestic loans in units of aggregate consumption, adds three important effects driven by real exchange rate fluctuations that alter standard models of Sudden Stops significantly: changes on the debt repayment burden, on the price of new debt, and on a risk-taking incentive (i.e., a negative premium on domestic debt). Under perfect foresight, the first effect makes Sudden Stops milder and multiple equilibria harder to obtain. The three effects add an “intermediation externality” to the macroprudential externality of standard models, which is present even without credit constraints. Optimal policy under commitment can be decentralized equally by taxing domestic credit or capital inflows, and hence capital controls as a separate instrument are *not* justified. This optimal policy is time inconsistent and follows a complex, nonlinear schedule. Quantitatively, an optimized pair of constant taxes on domestic debt and capital inflows makes crises slightly less likely and yields a small welfare gain, but other pairs reduce welfare sharply. For high effective debt taxes, capital controls and domestic debt taxes are again equivalent, and for low ones, welfare is higher with higher taxes on domestic debt than on capital inflows.

## JEL Classification

E31 E37 E52 F41## Notes

### Acknowledgements

This paper was prepared for the IMF’s Eighteenth Jacques Polak Annual Research Conference. We would like to thank Cristina Arellano for her insightful discussion and conference participants for helpful comments. We are also grateful for comments and suggestions by Javier Bianchi, Emine Boz, Markus Brunnermeier, and Linda Tesar and by participants at the 2018 AEA Annual Meetings, the XXIII Jornadas Anuales de Economía of the Central Bank of Uruguay, and the 2017 Workshop of the Financial Stability and Development Network of the IDB with the BIS-CCA.

## References

- Benigno, G., H. Chen, C. Otrok, A. Rebucci, and E.R. Young. 2016. Optimal capital controls and real exchange rate policies: A pecuniary externality perspective.
*Journal of Monetary Economics*84: 147–165.CrossRefGoogle Scholar - Bianchi, J. 2011. Overborrowing and systemic externalities in the business cycle.
*American Economic Review*101(7): 3400–3426.CrossRefGoogle Scholar - Bianchi, J., C. Liu, and E.G. Mendoza. 2016. Fundamentals news, global liquidity and macroprudential policy.
*Journal of International Economics*99(1): 2–15.CrossRefGoogle Scholar - Bianchi, J., and E.G. Mendoza. 2018. Optimal time-consistent macroprudential policy.
*Journal of Political Economy*126(2): 588–634.CrossRefGoogle Scholar - Calvo, G. 2002. On dollarization.
*Economics of Transition*10(2): 393–403.CrossRefGoogle Scholar - Céspedes, L., R. Chang, and A. Velasco. 2004. Balance sheets and exchange rate policy.
*American Economic Review*94(4): 1183–1193.CrossRefGoogle Scholar - Choi, W., and D. Cook. 2004. Liability dollarization and the bank balance sheet channel.
*Journal of International Economics*64(2): 247–275.CrossRefGoogle Scholar - Díaz-Alejandro, C.F. 1965.
*Exchange-rate devaluation in a semi-industrialized country: The experience of Argentina, 1955–1961*. Cambridge, MA: MIT Press.Google Scholar - Eichengreen, B., and R. Hausmann. 1999. Exchange rates and financial fragility. NBER Working Paper No. 7418.Google Scholar
- Hernández, J., and E.G. Mendoza. 2017. Optimal v. simple financial policy rules in a production economy with “liability dollarization”.
*Ensayos sobre Política Económica*35(82): 25–39.CrossRefGoogle Scholar - Korinek, A. 2011. The new economics of prudential capital controls: A research agenda.
*IMF Economic Review*59(3): 523–561.CrossRefGoogle Scholar - Lane, P., and G. Milesi-Ferretti. 2001. The external wealth of nations: Measures of foreign assets and liabilities for industrial and developing countries.
*Journal of International Economics*55(2): 263–294.CrossRefGoogle Scholar - Ljungqvist, L., and T. Sargent. 2004.
*Recursive macroeconomic theory*. Cambridge: MIT Press.Google Scholar - Mendoza, E.G. 2002. Credit, prices, and crashes: Business cycles with a sudden stop. In
*Preventing Currency Crises in Emerging Markets*, ed. Jeffrey A. Frankel and Sebastian Edwards, 335–392. Chicago: University of Chicago Press.CrossRefGoogle Scholar - Mendoza, E.G. 2005. Real exchange volatility and the price of nontradables in sudden-stop prone economies.
*Economia*, 103–148. Fall.Google Scholar - Mendoza, E.G., and E. Rojas. 2017.
*Liability dollarization, sudden stops and optimal financial policy*. Philadelphia: Mimeo, University of Pennsylvania.Google Scholar - Mendoza, E.G. 2010. Sudden stops, financial crises, and leverage.
*The American Economic Review*100(5): 1941–1966.CrossRefGoogle Scholar - Mendoza, E.G. 2016.
*Macroprudential policy: Promise and challenges*. NBER Working Paper No. 22868.Google Scholar - Obstfeld, M., and K. Rogoff. 1996.
*Foundations of international macroeconomics*. Cambridge, MA: MIT Press.Google Scholar - Salter, W. 1959. Internal and external balance: The role of price and expenditure effects.
*Economic Record*35(71): 226–238.CrossRefGoogle Scholar - Schmitt-Grohé, S., and M. Uribe. 2017. Adjustment to small, large, and sunspot shocks in open economies with stock collateral constraints.
*Ensayos sobre Política Económica*35(82): 2–9.CrossRefGoogle Scholar - Schmitt-Grohé, S., and M. Uribe. 2018.
*Multiple equilibria in open economy models with collateral constraints: Overborrowing revisited*. New York: Mimeo, Columbia University.Google Scholar - Swan, T. 1960. Economic control in a dependent economy.
*Economic Record*36(73): 51–66.CrossRefGoogle Scholar - Tauchen, G., and R. Hussey. 1991. Quadrature-based methods for obtaining approximate solutions to nonlinear asset pricing models.
*Econometrica*59: 371–396.CrossRefGoogle Scholar