- Steven Weisbrod, and Liliana Rojas-Suárez
- Published Date:
- October 1995
Assume that the authorities impose reserve requirements on the following:
domestic-currency-denominated deposits = k = 10 percent
foreign-currency-denominated deposits = j = 20 percent
Assume also that transactions that must be effected in domestic currency (payment for taxes, for example) are such that the public needs to hold a minimum of deposits denominated in domestic currency equal to $10. For simplicity, assume that the public holds no cash, so that its entire financial wealth takes the form of bank deposits. The exchange rate between U.S. dollars and domestic currency is assumed to equal 1.
An initial position can be characterized as follows (where bank capital has been netted out in the accounts):
|Domestic currency = 10||Domestic currency = 100|
|U.S. dollars = 20||U.S. dollars = 100|
|Domestic currency = 90|
|U.S. dollars = 80|
|Foreign exchange||Monetary base = 10|
|reserves = 30||Bank deposits in U.S. dollars = 20|
A lack of confidence in the announced exchange rate may lead to a shift away from the domestic currency. Hypothetically, if no other change occurs, the balance sheet may look as follows in the instant immediately after the shift away from domestic deposits.1
|Domestic currency = 0||Domestic currency = 0|
|U.S. dollars = 30||U.S. dollars = 200|
|Domestic currency = 90|
|U.S. dollars = 80|
|Foreign exchange||Monetary base = 0|
|reserves = 30||Bank deposits in U.S. dollars = 30|
Because the monetary authorities will not accommodate a speculative attack on the domestic currency, the interest rate on domestic-currency-denominated loans will rise. The increase will prevent a currency restructuring of domestic currency loans.
In the above balance sheets, banks are not satisfying reserve requirements in U.S. dollars, and, there-fore, that position is a disequilibrium one that could exist for only a brief time. The position also shows a mismatch in the currency composition of banks’ assets and liabilities. As the existing stock of loans de-nominated in domestic currency expires and as the public need to hold a minimum of $10 in domestic-currency-denominated deposits becomes binding, a possible outcome may be:
|Domestic currency = I||Domestic currency = 10|
|U.S. dollars = 29||U.S. dollars = 145|
|Domestic currency = 9|
|U.S. dollars = 116|
|Foreign exchange||Monetary base = I|
|reserves = 30||Bank deposits in U.S. dollars = 29|
In this outcome, the dollarization process has strengthened and will remain strong unless the public becomes convinced of the monetary authorities’ commitment to the exchange rate. Also, owing to a reserve requirement on U.S. dollar deposits higher than that on domestic-currency-denominated deposits, the new equilibrium involves a lower level of total loans to the economy. Notice that if k = j, total loans will have remained unchanged.
The dynamics toward the final position could take a variety of forms. The example presented here is chosen only for illustrative purposes.
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