Working Paper

Devaluations, Deposit Dollarization, and Household Heterogeneity

Abstract: We study the aggregate and re-distributive effects of currency devaluations in a small open economy heterogeneous households model with leverage-constrained banks. Our framework captures three stylized facts about liability dollarization in emerging economies: i) banks and firms borrow in foreign currency; ii) households save in dollar-denominated local bank deposits; and iii) such deposits are mainly held by wealthier households. The resulting currency mismatch causes an erosion of banks' net worth during a devaluation, depressing credit supply. The ensuing macroeconomic downturn is amplified by a strong reduction of consumption among poorer households in response to rising borrowing costs and falling labor income. Richer households are partially insured, as they are holding a larger share of their wealth in foreign currency denominated assets. We show that a larger currency hedging by wealthier households deepens the recession and amplifies the negative spillovers for poorer agents. When deposit dollarization is high, welfare gains can arise if monetary policy dampens a depreciation.

Keywords: Dollarization; Currency Depreciation; Household Heterogeneity; Redistribution;

JEL Classification: E21; F32; F41;

https://doi.org/10.17016/IFDP.2022.1336

Bibliographic Information

Provider: Board of Governors of the Federal Reserve System (U.S.)

Part of Series: International Finance Discussion Papers

Publication Date: 2022-02-16

Number: 1336