Financial Instability under a Flexible Exchange Rate*


  • *

    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.


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.