We would like to thank participants at the Conference on International Financial Crises, Orléans University, May 2004, as well as Kim Huynh, Barbara Katz and two anonymous referees for suggestions and remarks that helped us improve the quality of the paper.
Financial Instability under a Flexible Exchange Rate*
Article first published online: 28 AUG 2007
The Scandinavian Journal of Economics
Volume 109, Issue 2, pages 291–302, June 2007
How to Cite
Besancenot, D. and Vranceanu, R. (2007), Financial Instability under a Flexible Exchange Rate. The Scandinavian Journal of Economics, 109: 291–302. doi: 10.1111/j.1467-9442.2007.00498.x
- Issue published online: 28 AUG 2007
- Article first published online: 28 AUG 2007
- First version submitted May 2005;final version received May 2006.
- Exchange rate;
- dollar debt;
- rational expectations;
- financial crises;
- developing countries
Many governments in developing countries contemplate the possibility of increasing the flexibility of their exchange rates despite having accumulated substantial dollar-denominated debt. Using a model of corporate dollar debt in which the future exchange rate is uncertain, this paper studies the financial risks that might arise as a consequence of increased exchange rate flexibility. Since a firm may default on its debt either because its dollar income is too low or because investors refuse to roll over its debt, the measure of the overall risk of default should take into account both factors, as well as their interaction. Solving the model for the no-default rational expectations equilibrium, we find that a small risk of insolvency may bring about a substantial risk of illiquidity.