Currency Choices in Contracts

• Published in: IDEAS Working Paper Series from RePEc
• Main Authors: Drenik, Andres, Perez, Diego, Kirpalani, Rishabh
• Format: Paper
• Language: English
• Published: St. Louis Federal Reserve Bank of St. Louis 01.01.2018
• Subjects: Currency; Economic models; Foreign exchange rate risk

We study the optimal currency choice in contracts in an economy with credit chains and endogenous government-policy risk. Denominating contracts in local currency helps mitigate real exchange rate risk while denominating in a foreign currency (dollar) minimizes risks due to government policy, for example inflation. In the aggregate, the equilibrium currency denomination calls for a coordination of currencies in bilateral contracts within a chain to avoid costly default due to currency mismatch. This implies that the incentives to denominate in a foreign currency might persist even after government/political risk has been significantly reduced. Our model can help explain the observed hysteresis of dollarization that occurred in several Latin American countries. We also show that the socially optimal allocation would call for even more dollarization than is privately optimal in order to constrain the government's choices ex-post.