Domestic Lender Of Last Resort example essay topic

GLIM WORKING PAPER SERIES WANT DOLLARIZATION? NO! NO! Sundara B Reddy GREAT LAKES INSTITUTE OF MANAGEMENT South Mada Street, Srinagar Colony, Saida pet, Chennai July 2004 We are indebted to Lakshmi Kumar, Bala V Balachandran, Gul shan, Shishi r, Praveen for useful comments and suggestions. Of course, we are solely responsible for any shortcomings. The views expressed herein are those of the authors and not necessarily those of the Great Lakes Institute of Management. (c) 2004 by Sundara B Reddy.

All rights reserved. Short sections of text, not to exceed two paragraphs, may be quoted without explicit permission provided that full credit, including (c) notice, is given to the source. Want Dollarization? No! No! Sundara B Reddy GLIM Working Paper July 2004 JEL No.

E 42, F 41, F 42 ABSTRACT This paper discusses major analytical aspects of and their practical implications. We develop a simple model to stress that implies the loss of independent monetary policy, yet the significance of such losses can only be evaluated in conjunction with assumptions about the policymaking process. If the government is benevolent and has no credibility problems, causes a fall in welfare, which can be measured. However, outcomes are rather different if credibility is absent and can serve as a commitment device: the welfare impact of is ambiguous. We also evaluate other implications of, such as those related to last resort lending and financial stability. Sundara B Reddy 1 Introduction In the debate, some have indeed argued that dollars would provide for a"better" currency than existing national currencies while others have argued exactly the opposite.

We prefer to be agnostic here. Given the absence of better micro-foundations, it is probably best to impose an assumption that does not bias the desirability of in one way or another. Fixing the exchange rate involves a welfare loss relative to the Ramsey policy. So, in the absence of commitment, expected welfare under fixed exchange rates may or may not improve.

There is a trade off between credibility and flexibility, and the better choice depends on model parameters. 2 Dollarization and the Lender of Last Resort - 3 -The recent crises in emerging markets have underscored a crucial question: what is the role of exchange rate policy in the generation and / or prevention of those crises? Arguably, it is this issue that has provided the main impetus for proposals in developing countries. And, paradoxically, consideration of the same question has led to calls for the exact opposite, flexible exchange rates. The debate has been influenced by some prominent aspects of observed crises. In them, the financial system, and particularly domestic banks, played a key role.

Exchange rate pegs often collapsed as the central bank was attempting to bail out the domestic financial system in the midst of a panic. The panic was possible, in turn, because the countries that went into crises were in a state of international il liquidity: their short term potential liabilities, measured in international currency, clearly exceeded the value of the assets they could have access to on short notice. In this context, it has been argued that would make crises more likely by preventing the domestic central bank from acting as a domestic lender of last resort. Loosely speaking, a lender of last resort is an institution that stands ready to provide credit to banks in the event that they experience a sudden demand for liquidity, as when bank runs occur. Such an institution is crucial in a system of banks with fractional reserves in order to reassure bank depositors and short-term creditors that their claims on the banks will always be honored if they attempt to liquidate them. This may help prevent confidence crises and associated bank runs.

- 1 -In most countries, the role of lender of last resort has traditionally been played by central banks. This role is natural because the central bank can create credit quickly and at a negligible cost simply by issuing domestic currency. But the ability to print currency would disappear under, and hence the central bank would no longer be able to serve as the lender of last resort. Advocates of admit that it would prevent the central bank from acting as a domestic lender of last resort, but that this may not be too difficult to deal with. One way to cope with the possibility of financial panics, which Argentina actually implemented, would be to secure foreign lines of short term credit to be drawn upon in the event of a run. This suggests that the welfare impact of losing the central bank's ability to be the lender of last resort can be measured by the cost of a contingent line of credit large enough to prevent runs.

What " large enough" means is debatable. In light of our model, and recalling the meaning of international il liquidity, the size of the credit line should be at least as large as the gap between the potential short run liabilities and assets of the financial system, which can be substantial. In particular, the Argentinean credit lines are unlikely to have met this criterion. On the other hand, the "commitment rate" at which the Argentinean lines were secured were small enough that the total cost of the strategy would have been relatively small even if the credit line had to increase several fold. In the same scenario, the contractual interest rate on loans to the home country would be higher than the world interest rate in cases in which runs occurred with nonzero probability. This risk premium would compensate foreign creditors for the probability of debt default.

But the implication is that, in this model, may well be associated with an increase in the dollar interest rate applicable to the home country. This is in contrast with claims that would reduce the cost of foreign credit. 3 Some Arguments in Need of a Theory There are a number of arguments related to the debate that, to date, have not been formalized with the tools of modern economic theory. Many of these arguments sound plausible, but their relative importance will remain unknown unless more progress is made in formulating them adequately. - 2 -The first contention is that would be beneficial by reducing transactions costs, such as the costs of calculating dollar equivalents of national currency quantities. In principle, one can hardly disagree with this claim.

However, measuring its significance is much trickier. For one thing, the transactions costs relevant for the argument are likely to be very small. Also, including them into economic models has proven to be much harder than expected, and no satisfactory and tractable procedure has emerged. As a consequence, measures of the quantitative importance of transactions costs have played little role in the debate. Finally, the transactions costs in question are likely to be already negligible in a system of irrevocably fixed exchange rates, and hence the marginal savings that would bring along this dimension are arguably insignificant. A second argument, this one voiced by some opponents of, is that currencies are national symbols, and hence their elimination would be costly in terms of national pride, identity, and the like.

Such an argument is sometimes politically effective and, in spite of its being quickly dismissed by many economists, may have some validity. However, how to formalize it or assess its economic importance is completely unknown. A third claim is that would reduce market incompleteness. For example, Hausmann (1999) stated that " [Dollarization] would expand the menu of financial options open to emerging-market governments and firms and, in so doing, would increase financial stability". Again, this is not an implausible claim, but is one that cannot be analyzed in the context of standard models.

This is because standard models take the degree of market completeness as a given. To our knowledge, there is no theory dealing with how would "expand the menu of financial options", let alone what implications such an expansion would have on allocations and welfare. Finally, consider the claim that official is presumably beneficial because it would legalize the spontaneous that is already observed in several countries. At one level, our analysis can be amended in a straightforward manner to deal with such an argument. One may suppose that, before is imposed by policy, the home agent derives utility not only from holding pesos but also from holding dollars. This can be formalized by making vs. depend on some aggregate of the real value of pesos and dollars, a modeling device that has been employed in the literature on currency substitution.

The resulting extension is likely to yield essentially the same lessons as the original model and, in that sense, the observation of currency substitution by itself does not provide independent support for. - 3 -We admit, though, that the fact that is already taking place in many countries may reflect the effect of some fundamentals about which we know little or nothing. Given this, it may be not implausible to conjecture that the way such fundamentals work may change, in a favorable way, if was made official. However, such a conjecture needs to be made explicit and cast in terms of modern economic theory if it is to become more than wishful thinking. 4 Final Remarks We have conducted a fairly thorough, although surely not exhaustive, discussion of the theoretical issues associated with. Our analysis has been organized around a simple, single framework, which can be extended in many directions.

We emphasize that the study of a single framework is useful for at least two reasons. It gives an idea of how the different aspects of the debate are related to each other. We have borrowed from previous literature, and we have also provided new observations, against. For this we emphasized that there is no presumption that should reduce interest rates. Perhaps most importantly, we have identified some arguments that are lacking satisfactory theoretical foundations.

Given the interest on, these arguments remain fertile ground for future research.