Financial Crises and Lending of Last Resort in Open Economies

We study a small open economy with flexible exchange rates and financial intermediaries that face a potentially binding collateral constraint. The model features the possibility of a self-fulfilling crisis with persistent... [ view full abstract ]

We study a small open economy with flexible exchange rates and financial intermediaries that face a potentially binding collateral constraint. The model features the possibility of a self-fulfilling crisis with persistent effects on real activity, that produces a current account reversal and a real devaluation. The presence of dollarized liabilities in the financial sector makes a crisis more likely. We show that financial dollarization can arise endogenously because domestic households have a precautionary motive to save in dollars when they expect a crisis with sufficiently high probability, as dollar assets provide insurance against financial crises. The domestic government can intervene in financial markets to eliminate the crisis equilibrium, but the intervention only works if it is fiscally credible. Holdings of foreign currency reserves can help make interventions credible, thus improving financial stability and reducing exchange rate volatility.