Introducing Liability Dollarization and Contractionary Depreciations to the IS Curve

Adam Honig

Department of Economics, Amherst College, Amherst, USA.

DOI: 10.4236/me.2012.34061                

Abstract

This paper presents a simple modification to the standard IS curve used, at least implicitly, by policymakers that allows capital flight to have a contractionary effect in emerging market economies. In the standard model, capital flight leads to an expansionary shift in the IS curve through an increase in net exports. However, in the presence of liability dollarization for domestic firms, a currency depreciation triggered by capital flight leads to an investment collapse. A simple adjustment to the standard investment schedule captures this channel and allows for the possibility that capital flight yields a contractionary shift in the IS curve.

Keywords

Liability Dollarization; IS Curve

Conflicts of Interest

The authors declare no conflicts of interest.

References

[1]	O. Blanchard, “Macroeconomics,” 5th Edition, Prentice Hall, Upper Saddle River, 2009.
[2]	N. G. Mankiw, “Macroeconomics,” 7th Edition, Worth Publishers, Richmond, 2010.
[3]	F. S. Mishkin, “Macroeconomics: Policy and Practice,” Prentice Hall, Upper Saddle River, 2011.
[4]	A. Abel, B. Bernanke and D. Croushore, “Macroeconomics,” 6th edition, Prentice Hall, Upper Saddle River, 2007.
[5]	G. De Nicoló, P. Honohan and A. Ize, “Dollarization of the Banking System: Causes and Consequences,” Journal of Banking and Finance, Vol. 29, 2005, No. 7, pp. 1697- 1727. doi:10.1016/j.jbankfin.2004.06.033
[6]	F. S. Mishkin, “Understanding Financial Crises: A Developing Country Perspective,” In: M. Bruno and B. Pleskovic, Eds., Annual World Bank Conference on Development Economics, World Bank, Washington DC, 1996, pp. 29-62.
[7]	B. S. Bernanke and M. Gertler, “Agency Costs, Net Worth, and Business Fluctuations,” American Economic Review, Vol. 79, No. 1, 1989, pp. 14–31.
[8]	P. Krugman, “Balance Sheets, the Transfer Problem, and Financial Crises,” Princeton University, Princeton, 1999.
[9]	J. Frankel, “Contractionary Currency Crises in Developing Countries,” NBER Working Paper No. 11508, 2005.
[10]	P. Aghion, P. Bacchetta, and A. Banerjee, “A Simple Model of Monetary Policy and Currency Crises,” European Economic Review, Vol. 44, No. 4-6, 2000, 728-738. doi:10.1016/S0014-2921(99)00053-7
[11]	L. F. Céspedes, R. Chang and A. Velasco. “Balance Sheets and Exchange Rate Policy,” American Economic Review, Vol. 94, No. 4, 2004, pp. 1183-1193. doi:10.1257/0002828042002589
[12]	A. Galindo, U. Panizza and F. Schiantarelli, “Debt Composition and Balance Sheet Effects of Currency Depreciation: A Summary of the Micro Evidence,” Emerging Markets Review, Vol. 4, No. 4, 2003, pp. 330-339. doi:10.1016/S1566-0141(03)00059-1
[13]	M. Aguiar, “Investment, Devaluation, and Foreign Currency Exposure: The Case of Mexico,” Journal of Devel- opment Economics, Vol. 78, No. 1, 2005, pp. 95-113. doi:10.1016/j.jdeveco.2004.06.012
[14]	R. Bebczuk, A. Galindo and U. Panizza, “An Evaluation of the Contractionary Devaluation Hypothesis,” InterAmerican Development Bank Working Paper 582, 2006.