Transcript Chapter 2

Chapter 2
The Financial System,
Money Demand,
and Monetary Policy
© Pierre-Richard Agénor
The World Bank
1





The Financial System
Indirect Instruments of Monetary Policy
Credit Rationing
Monetary Policy in a Dollarized Economy
The Demand for Money
2



Key features of financial system in
developing countries :
low degree of institutional diversification;
limited availability of financial assets;
importance of government intervention.
3
The Financial System



Figure 2.1.
Financial Repression
Banks and Financial Intermediation
4
F
i
g
u
r
e
2
.
1
a
F
i
n
a
n
c
i
a
l
D
e
p
t
h
a
n
d
P
e
r
C
a
p
i
t
a
I
n
c
o
m
e
1
/
(
A
v
e
r
a
g
e
o
v
e
r
1
9
8
0
9
5
)
5
0
N
a
r
r
o
w
M
o
n
e
y
(
i
n
p
e
r
c
e
n
t
o
f
G
D
P
)
4
0
3
0
2
0
1
0
0
0
5
0
0
0
1
0
0
0
0
1
5
0
0
0
2
0
0
0
0
P
e
r
c
a
p
i
t
a
r
e
a
l
G
D
P
i
n
1
9
8
7
U
S
d
o
l
l
a
r
s
S
o
u
r
c
e
:
W
o
r
l
d
B
a
n
k
.
1
/
4
4
d
e
v
e
l
o
p
i
n
g
c
o
u
n
t
r
i
e
s
a
n
d
1
5
i
n
d
u
s
t
r
i
a
l
i
z
e
d
c
o
u
n
t
r
i
e
s
a
r
e
i
n
c
l
u
d
e
d
.
A
d
a
r
k
c
i
r
c
l
e
r
e
f
e
r
s
t
o
d
e
v
e
l
o
p
i
n
g
c
o
u
n
t
r
i
e
s
a
n
d
a
l
i
g
h
t
e
r
c
i
r
c
l
e
t
o
i
n
d
u
s
t
r
i
a
l
c
o
u
n
t
r
i
e
s
.
5
F
i
g
u
r
e
2
.
1
b
F
i
n
a
n
c
i
a
l
D
e
p
t
h
a
n
d
P
e
r
C
a
p
i
t
a
I
n
c
o
m
e
1
/
(
A
v
e
r
a
g
e
o
v
e
r
1
9
8
0
9
5
)
1
4
0
B
r
o
a
d
M
o
n
e
y
(
i
n
p
e
r
c
e
n
t
o
f
G
D
P
)
1
2
0
1
0
0
8
0
6
0
4
0
2
0
0
0
5
0
0
0
1
0
0
0
0
1
5
0
0
0
2
0
0
0
0
P
e
r
c
a
p
i
t
a
r
e
a
l
G
D
P
i
n
1
9
8
7
U
S
d
o
l
l
a
r
s
S
o
u
r
c
e
:
W
o
r
l
d
B
a
n
k
.
1
/
4
4
d
e
v
e
l
o
p
i
n
g
c
o
u
n
t
r
i
e
s
a
n
d
1
5
i
n
d
u
s
t
r
i
a
l
i
z
e
d
c
o
u
n
t
r
i
e
s
a
r
e
i
n
c
l
u
d
e
d
.
A
d
a
r
k
c
i
r
c
l
e
r
e
f
e
r
s
t
o
d
e
v
e
l
o
p
i
n
g
c
o
u
n
t
r
i
e
s
a
n
d
a
l
i
g
h
t
e
r
c
i
r
c
l
e
t
o
i
n
d
u
s
t
r
i
a
l
c
o
u
n
t
r
i
e
s
.
6
Financial Repression





State of financial repression is defined as:
ceilings on nominal interest rates;
quantitative controls and selective credit
allocation across government considered priority
sectors, regions or activities;
high minimum reserve requirement;
loan decisions of state owned banks are guided by
political factors;
forced allocation of assets or loans to the public
sector by private commercial banks, for example,
statutory liquidity ratios (required to hold a
proportion of assets in the form of government debt).
7





Interest rate ceiling may distort the economy by:
increasing the preference of individuals for current
consumption as opposed to future consumption, as
a result, by reducing savings;
reducing the supply of funds through the banking
system (disintermediation);
leading bank borrowers to choose more capitalintensive project due to low interest rate on loans;
financing low-yielding project more heavily.
Motivation for financial repression: inability to raise
taxes either due to administrative inefficiencies
or political constraints.
8





Government manipulates the financial system to
promote its development goals through financial
repression.
Financial repression yield substantial revenue to the
government.
First source: implicit tax on financial
intermediation by high reserve requirement rates.
Second source: implicit subsidy; government
benefits by obtaining access to central bank
financing at below-market interest rates.
Giovannini and De Melo (1993): on average,
governments in their sample of developing
countries extracted about 2% of GDP in revenue
from financial repression.
9
Implications of financial repression:
 severe inefficiencies;
 restrict the development of financial
intermediation;
 increase the spread between deposit and
lending rates;
 and reduce saving and investment in the
economy;
 arise informal modes of financial
intermediation;
 alter substantially the transmission process of
monetary policy.
10
Banks and Financial Intermediation





Banks dominate the financial system in most
developing countries.
Bank deposits: most important form of household
savings.
Bank loans: most important source of finance for
firms.
Figure 2.2: share of domestic credit provided by
banks in proportion to GDP is high.
Equity markets: increase in size in several
developing countries (Figure 2.3).
11
F
i
g
u
r
e
2
.
2
a
D
o
m
e
s
t
i
c
C
r
e
d
i
t
P
r
o
v
i
d
e
d
b
y
B
a
n
k
i
n
g
S
e
c
t
o
r
(
I
n
p
e
r
c
e
n
t
o
f
G
D
P
)
1
9
9
5
1
9
9
0
A
s
i
a
A
f
r
i
c
a
B
e
n
i
n
B
a
n
g
l
a
d
e
s
h
B
u
r
u
n
d
i
I
n
d
i
a
C
ô
t
e
d
'
I
v
o
i
r
e
I
n
d
o
n
e
s
i
a
E
t
h
i
o
p
i
a
K
o
r
e
a
G
a
b
o
n
G
h
a
n
a
M
a
l
a
y
s
i
a
K
e
n
y
a
P
a
k
i
s
t
a
n
M
a
l
a
w
i
P
h
i
l
i
p
p
i
n
e
s
N
i
g
e
r
i
a
S
i
n
g
a
p
o
r
e
T
a
n
z
a
n
i
a
S
r
i
L
a
n
k
a
Z
a
m
b
i
a
T
h
a
i
l
a
n
d
Z
i
m
b
a
b
w
e
0
5
0
S
o
u
r
c
e
:
W
o
r
l
d
B
a
n
k
.
1
0
0
0
2
0
4
0
6
0
8
0
1
0
0
1
2
0
1
4
0
12
F
i
g
u
r
e
2
.
2
b
D
o
m
e
s
t
i
c
C
r
e
d
i
t
P
r
o
v
i
d
e
d
b
y
B
a
n
k
i
n
g
S
e
c
t
o
r
(
I
n
p
e
r
c
e
n
t
o
f
G
D
P
)
1
9
9
0
1
9
9
5
M
i
d
d
l
e
E
a
s
t
a
n
d
N
o
r
t
h
A
f
r
i
c
a
L
a
t
i
n
A
m
e
r
i
c
a
A
r
g
e
n
t
i
n
a
A
l
g
e
r
i
a
B
o
l
i
v
i
a
E
g
y
p
t
B
r
a
z
i
l
J
o
r
d
a
n
C
h
i
l
e
M
a
u
r
i
t
a
n
i
a
C
o
l
o
m
b
i
a
M
o
r
o
c
c
o
C
o
s
t
a
R
i
c
a
O
m
a
n
E
c
u
a
d
o
r
H
o
n
d
u
r
a
s
S
a
u
d
i
A
r
a
b
i
a
J
a
m
a
i
c
a
S
y
r
i
a
M
e
x
i
c
o
T
u
n
i
s
i
a
P
e
r
u
T
u
r
k
e
y
U
r
u
g
u
a
y
Y
e
m
e
n
V
e
n
e
z
u
e
l
a
0
5
0
S
o
u
r
c
e
:
W
o
r
l
d
B
a
n
k
.
1
0
0
0
3
5
7
0
1
0
5 1
4
0
13
F
i
g
u
r
e
2
.
3
S
t
o
c
k
M
a
r
k
e
t
C
a
p
i
t
a
l
i
z
a
t
i
o
n
(
I
n
p
e
r
c
e
n
t
o
f
G
D
P
)
1
9
9
0
A
r
g
e
n
t
i
n
a
B
r
a
z
i
l
C
h
i
l
e
C
o
l
o
m
b
i
a
C
ô
t
e
d
'
I
v
o
i
r
e
1
9
9
5
K
o
r
e
a
M
e
x
i
c
o
M
o
r
o
c
c
o
N
i
g
e
r
i
a
P
a
k
i
s
t
a
n
E
c
u
a
d
o
r
E
g
y
p
t
P
e
r
u
P
h
i
l
i
p
p
i
n
e
s
G
h
a
n
a
S
r
i
L
a
n
k
a
I
n
d
i
a
T
h
a
i
l
a
n
d
I
n
d
o
n
e
s
i
a
T
u
n
i
s
i
a
J
o
r
d
a
n
T
u
r
k
e
y
K
e
n
y
a
V
e
n
e
z
u
e
l
a
0
2
0
4
0
6
0
8
0
1
0
0
1
2
0
1
4
0
0
2
0
4
0
6
0
8
0
1
0
0
1
2
0
1
4
0
S
o
u
r
c
e
:
W
o
r
l
d
B
a
n
k
.
N
o
t
e
:
S
t
o
c
k
m
a
r
k
e
t
c
a
p
i
t
a
l
i
z
a
t
i
o
n
i
s
t
h
e
s
h
a
r
e
p
r
i
c
e
t
i
m
e
s
t
h
e
n
u
m
b
e
r
o
f
s
h
a
r
e
s
o
u
t
s
t
a
n
d
i
n
g
f
o
r
a
l
l
l
i
s
t
e
d
d
o
m
e
s
t
i
c
c
o
m
p
a
n
i
e
s
.
14





Results of development in equity markets:
allow greater dispersion of risk;
more efficient allocation of resources;
greater mobilization of savings;
active secondary markets in government debt help
to conduct monetary policy through indirect
instruments.
In most developing countries, corporate bond
markets remain quite narrow, concentrated, and
relatively illiquid.
15



Main functions of banks:
transformation: transform the short-term, liquid
deposits held by households into illiquid liabilities
issued by firms;
delegated screening and monitoring: screen
potential borrowers and monitor actual borrowers
on behalf of depositors;
facilitate transactions : between agents (firms and
workers, buyers and sellers) by providing payment
services.
16



Problems in banking system:
Inadequate prudential supervision: create
systemic fragility and may precipitate bank runs and
currency crises.
This complicates the conduct of monetary policy
since banks that are less able to control their
balance sheets will be less responsive to changes
in the base money stock or interest rates.
Problems may lead to pressure on the central bank
to extend credit to bail out troubled banks.
17
Indirect Instruments of
Monetary Policy
18





Under financial repression central banks use direct
instruments of monetary policy.
Problems:
create severe inefficiencies in credit allocation and
the financial intermediation process;
lose effectiveness of direct instruments since agents
start to rely on informal credit channels.
As a result, many countries have liberalized their
financial systems and adopted indirect instruments
of monetary management.
Indirect instruments of monetary policy are market
based and operate essentially through interest
rates.
19



Main purpose: affect overall monetary and credit
conditions through changes in the supply and
demand for liquidity.
Indirect instruments:
 open-market operations;
 refinance and discount facilities;
 reserve requirement.
Open-market operations:
The direct sale or purchase of financial instruments
(treasury bills or central bank paper) in the
secondary market for securities or through central
bank intervention in primary markets for securities
to influence the level of liquid reserves held by
20
commercial banks.



Repurchase agreements: acquisition of financial
instruments by the central bank under a contract
stipulating an agreed date and a specified price for
the resale of these instruments; and reverse
repurchase agreements.
In contrast with direct operations, these agreements
provide temporary financing of cash shortages and
surpluses, but do not directly influence supply and
demand in the instrument used as collateral.
Refinance and discount facilities:
Short-term lending operations that involve
rediscounting high-quality financial assets (such as
treasury bills) by the central bank.
21



Reserve requirements:
Remunerated reserve requirements: commercial
banks must hold a specified part of their assets in
the form of reserves at the central bank.
All these instruments allow policymakers to exercise
greater flexibility in implementing monetary policy.
Process of financial liberalization accompanied by
increased reliance on the use of indirect
instruments in developing countries.
22




Problems in conduction of open-market
operations:
If volume of central bank transactions is larger than
total volume of transactions in the secondary market,
sales of government securities by the central bank
may lead to a rise in interest rates on these securities
This raises the domestic debt burden of the
government.
In this case, repurchase operations may be
preferable.
Other problem: conflict arises between monetary
management objectives and debt management
objectives when monetary policy relies on primary
market sales of government securities.
23
Credit Rationing
24




Because of imperfect or asymmetric information
between banks and borrowers, probability that the
borrower will actually repay the loan is less than
unity.
Stiglitz and Weiss (1981) showed credit rationing
may emerge endogenously.
Credit Rationing:
As the interest rate on the loan increases, the
probability of repayment may decline.
Banks has less incentive to lend in such conditions
and they may even stop lending completely.
25




Stiglitz-Weiss model:
Assume:
Economy populated by a bank and a group of
borrowers, each of whom has a single, one-period
project in which he (or she) can invest.
Each project requires a fixed amount of funds, L,
and this is the amount that each borrower must
obtain to implement the project.
Each borrower must pledge collateral in value C <
L.
Each project requiring funding has a distribution of
gross payoffs, F(R,);
 R: project's return and borrower cannot affect it;
26
 : measures the riskiness of the project.




Projects yield either R (if they succeed) or 0 (if they
fail).
The higher value  represents an increase in risk.
An increase in  captures an increase in the
variance of the project's return, while leaving its
mean constant. Shifts in  are thus assumed to be
mean preserving.
Borrower receives the fixed amount of loans, L, at
the contractual interest rate r and defaults on the
loan if the project's return R plus the value of the
collateral C are insufficient to repay the loan.
Bank receives either the full contractual amount
(1+r)L or the maximum possible, R + C.
27

If lenders face no collection or enforcement
costs, the return to the bank is:
min {R + C ; (1+r) L}

Return to the borrower:
max {R - (1+r) L; - C}


For a given contractual interest rate,
~ r, there is a
~
critical value of , say , such that an agent will
borrow to invest if, and only if,  > .
Interest rate serves as a screening device.
28


Increase in r triggers two types of effects:
adverse selection effect (rise in the threshold
~
value ):
 by increasing the riskiness of the pool of
applicants, less risky borrowers drop out of the
market;
adverse incentive effect, or moral hazard effect:
 Borrowers are induced to choose projects for
which the probability of default is higher (because
riskier projects are associated with higher
expected returns).
 This has a negative effect on the lender's expected
profit, which may dominate the positive effect of an
29
increase in the contractual interest rate.
~
First result (/r > 0):


positive effect of an increase in the contractual
interest rate on the bank's expected rate of return
on its loans, , may be partly offset by the negative
effect due to the increase in the riskiness of the
pool of borrowers.
If the latter effect dominates,  will not be
monotonically related to r and rationing may incur
in equilibrium.
30



Figure 2.4:
Ld: demand for loanable funds; Ls: supply of
loanable funds; both as functions of the contractual
loan rate, r.
Ld: negative function of r.
~
s
L : positively related to r only up to r.


~
increases in r beyond r trigger adverse
selection and incentive effects, which lead to
decreasing amounts of credit offered to
borrowers.
Thus, Ls curve has a concave shape.
31
F
i
g
u
r
e
2
.
4
I
n
t
e
r
e
s
t
R
a
t
e
D
e
t
e
r
m
i
n
a
t
i
o
n
i
n
t
h
e
S
t
i
g
l
i
t
z
W
e
i
s
s
C
r
e
d
i
t
R
a
t
i
o
n
i
n
g
M
o
d
e
l
L
d
L
e
x
c
e
s
s
d
e
m
a
n
d
A
s
L
L
4
5
º
~
r
s
L
r
R
R
B

S
o
u
r
c
e
:
A
d
a
p
t
e
d
f
r
o
m
S
t
i
g
l
i
t
z
a
n
d
W
e
i
s
s
(
1
9
8
1
,
p
.
3
9
7
)
.
32





 is the product of r and the probability of
repayment.
Owing to the adverse selection and incentive
effects, the repayment probability declines by more
than the increase in r beyond ~r.
So the relationship between  and r is
nonmonotonic (RR curve) and RR is more concave
shape than Ls.
There is a positive relationship between  and Ls
(Southwest panel of Figure 2.4).
The northwest panel shows a 45-degree line
mapping of the equilibrium loan amount and Ls.
33

Point A gives value of r that ensures equality
between Ls and Ld.

Credit-rationing equilibrium occurs at the interest
~
rate r,
where  is at its maximum level.

Market-clearing interest rate is not optimal for the
bank, because at that level bank profits are less
than at ~r.
It is also inefficient, because borrowers with high
repayment probabilities drop out and are replaced
by those with high default risk.

34




~
The non-market-clearing rate r is both optimal and
efficient, because bank profits are at a maximum
level and risky borrowers are rationed out.
Thus, under imperfect information, lending rates
that are below market-clearing levels can be
observed even in competitive credit markets.
Such non-market-clearing lending rates reflect an
efficient response to profit opportunities.
Implication:
Increases in interest rates, beyond credit-rationing
level, can be counterproductive.
35




Stiglitz-Weiss model is helpful to understand why in
some developing countries bank credit is severely
rationed with bank lending rates unresponsive to
excess demand for credit.
Kaufman (1996) used the Stiglitz-Weiss model to
explain some of the aspects of Argentina's
economic crisis of 1995-96.
Degree of riskiness of projects can be
endogenously related to the level of economic
activity---which itself depends on the amount of
loans available.
This link creates a channel through which credit
rationing can be exacerbated and may display
persistence over time.
36





Stiglitz-Weiss model may also be useful to explain
the high holdings of excess reserves by
commercial banks in developing countries.
In an environment in which the probability of default
on loan commitments is high, excess reserves will
also tend to be high.
Figure 2.5: evolution of excess liquid assets held by
deposit money banks in Thailand, before and after
the financial and economic crisis that erupted in mid
1997.
Very sharp increase in excess liquidity in the
immediate aftermath of the crisis.
But this increase could also be, at least in part,
demand induced.
37
F
i
g
u
r
e
2
.
5
T
h
a
i
l
a
n
d
:
E
x
c
e
s
s
L
i
q
u
i
d
A
s
s
e
t
s
,
1
9
9
6
9
8
(
i
n
p
e
r
c
e
n
t
o
f
t
o
t
a
l
d
e
p
o
s
i
t
s
i
n
c
o
m
m
e
r
c
i
a
l
b
a
n
k
s
)
1
4
1
2
B
a
h
t
C
r
i
s
i
s
(
J
u
l
y
2
)
1
0
8
6
4
2
Jan.196
Apr.196
Jul.196
Oct.196
Jan.197
Apr.197
Jul.197
Oct.197
Jan.198
Apr.198
Jul.198
Oct.198
0
S
o
u
r
c
e
:
B
a
n
k
o
f
T
h
a
i
l
a
n
d
a
n
d
I
n
t
e
r
n
a
t
i
o
n
a
l
M
o
n
e
t
a
r
y
F
u
n
d
.
38




In general, nevertheless, the effectiveness of
monetary policy actions depends importantly on
whether banks are holding excess liquid reserves or
not;
degree to which interest rates can be deemed
sensitive to changes in excess reserves;
degree to which bank lending decisions are
influenced by the perceived riskiness of potential
borrowers.
Limitations of Stiglitz-Weiss model:
Assumption that lenders are completely unable to
assess the degree of riskiness of potential
borrowers.
39
Banks have incentives to invest in screening
technologies in order to acquire information
about the risk characteristics of their customers.
 This is particularly plausible in a dynamic context.
Role of collateral, C:
 Wette (1983): adverse selection effects similar to
those emphasized by Stiglitz and Weiss may
result if lenders attempt to raise mean returns by
increasing the collateral required from borrowers.
 Bester (1985): if lenders can vary both collateral
requirements and the contractual loan rate to
screen loan applicants, the possibility of a
rationing equilibrium disappears.


40
Stiglitz and Weiss (1992): even if banks are able
to manipulate interest rates and collateral,
rationing may still emerge in equilibrium if
borrowers are subject to decreasing absolute
risk aversion.
Absence of collection and verification costs.
 Asymmetry of information is ex ante: although
projects differ in their distributions of return before
implementation, lenders can observe actual
outcomes.
 Williamson (1986): assume that projects are ex
ante identical but lenders must incur ex post
monitoring and enforcement costs to
 verify the outcome of the project and
41


legally enforce the terms of the loan contract if
the borrower chooses to default.
 Credit market imperfections may be particularly
relevant for developing countries, where
enforcement of loan contracts may be difficult
due to the severe weaknesses in the legal
system.

42
Monetary Policy in a
Dollarized Economy
43



Dollarization (currency substitution): foreign
currency is used as a unit of account, store of value,
and a medium of exchange, concurrently with the
domestic currency.
Figure 2.6: dollarization (proportion of foreign
currency deposits held in the banking system
relative to the domestic broad money stock) has
been at times pervasive.
Figure 2.7: dollarization ratio grew significantly
during the period, in line with the increase in
inflation rates in Turkey.
44
S
o
u
r
c
e
:
I
n
t
e
r
n
a
t
i
o
n
a
l
M
o
n
e
t
a
r
y
F
u
n
d
.
1985q
1988
199
19
1985q1
1988q1
1991q1
1994q1
0
0
5
5
10
10
15
15
20
20
25
25
30
Bo
liv
30
(
I
n
p
r
o
p
o
r
t
i
o
n
o
f
t
h
e
d
o
m
e
s
t
i
c
b
r
o
a
d
m
o
n
e
y
s
t
o
c
k
)
F
o
r
e
i
g
n
C
u
r
r
e
n
c
y
D
e
p
o
s
i
t
s
H
e
l
d
i
n
t
h
e
D
o
m
e
s
t
i
c
B
a
n
k
i
n
g
S
y
s
t
e
m
F
i
g
u
r
e
2
.
6
a
45
F
i
g
u
r
e
2
.
6
b
F
o
r
e
i
g
n
C
u
r
r
e
n
c
y
D
e
p
o
s
i
t
s
H
e
l
d
i
n
t
h
e
D
o
m
e
s
t
i
c
B
a
n
k
i
n
g
S
y
s
t
e
m
(
I
n
p
r
o
p
o
r
t
i
o
n
o
f
t
h
e
d
o
m
e
s
t
i
c
b
r
o
a
d
m
o
n
e
y
s
t
o
c
k
)
5
4
3
M e
x
3
2 .5
2
1 .5
2
1
1
0 .5
0
0
11
9
1
9
8
1
9
8
5
9
9
8
q
9
1
q
1
4
q
1
q
1
1
1
1
9
1
9
8
1
9
8
5
9
9
8
q
S
o
u
r
c
e
:
I
n
t
e
r
n
a
t
i
o
n
a
l
M
o
n
e
t
a
r
y
F
u
n
d
.
46
F
i
g
u
r
e
2
.
6
c
F
o
r
e
i
g
n
C
u
r
r
e
n
c
y
D
e
p
o
s
i
t
s
H
e
l
d
i
n
t
h
e
D
o
m
e
s
t
i
c
B
a
n
k
i
n
g
S
y
s
t
e
m
(
I
n
p
r
o
p
o
r
t
i
o
n
o
f
t
h
e
d
o
m
e
s
t
i
c
b
r
o
a
d
m
o
n
e
y
s
t
o
c
k
)
2
1.5
Tu
r
10
8
6
1
4
0.5
2
0
0
1985q
1988
199
19
1985q1
1988q1
1991q1
1994q1
S
o
u
r
c
e
:
I
n
t
e
r
n
a
t
i
o
n
a
l
M
o
n
e
t
a
r
y
F
u
n
d
.
47
S
o
u
r
c
e
:
I
n
t
e
r
n
a
t
i
o
n
a
l
M
o
n
e
t
a
r
y
F
u
n
d
a
n
d
o
f
f
i
c
i
a
l
e
s
t
i
m
a
t
e
s
.
1
9
8
8
1
9
9
0
1
9
9
2
1
9
9
4
1
9
9
6
1
9
8
8
1
9
9
0
1
9
9
2
1
9
9
4
1
9
9
6
6
3
0
4
4
0
2
5
0
I
n
f
l
a
t
i
o
n
6
0
0
7
0
2
8
0
4
9
0
6
D
o
m
e
s
t
i
c
c
r
e
d
i
t
g
r
o
w
t
h
1
0
0
8
1
1
0
1
0
1
2
0
R
e
a
l
G
D
P
g
r
o
w
t
h
1
2
M
o
n
e
y
,
c
r
e
d
i
t
a
n
d
p
r
i
c
e
s
1
3
0
R
e
s
e
r
v
e
m
o
n
e
y
g
r
o
w
t
h
(
I
n
p
e
r
c
e
n
t
p
e
r
a
n
n
u
m
,
u
n
l
e
s
s
o
t
h
e
r
w
i
s
e
i
n
d
i
c
a
t
e
d
)
T
u
r
k
e
y
:
M
a
c
r
o
e
c
o
n
o
m
i
c
I
n
d
i
c
a
t
o
r
s
,
1
9
8
7
9
6
2
.
7
a
F
i
g
u
r
e
48
1
/
S
h
a
r
e
o
f
f
o
r
e
i
g
n
c
u
r
r
e
n
c
y
d
e
p
o
s
i
t
s
i
n
t
o
t
a
l
b
a
n
k
d
e
p
o
s
i
t
s
.
S
o
u
r
c
e
:
I
n
t
e
r
n
a
t
i
o
n
a
l
M
o
n
e
t
a
r
y
F
u
n
d
a
n
d
o
f
f
i
c
i
a
l
e
s
t
i
m
a
t
e
s
.
1
9
8
8
1
9
9
0
1
9
9
2
1
9
9
4
1
9
9
6
1
9
8
8
1
9
9
0
1
9
9
2
1
9
9
4
1
9
9
6
1
0
0
8
1
0
F
i
s
c
a
l
a
c
c
o
u
n
t
b
a
l
a
n
c
e
6
2
0
4
3
0
2
4
0
0
2
C
u
r
r
e
n
t
a
c
c
o
u
n
t
b
a
l
a
n
c
e
5
0
F
i
s
c
a
l
a
n
d
c
u
r
r
e
n
t
a
c
c
o
u
n
t
b
a
l
a
n
c
e
(
i
n
%
G
D
P
)6
0
D
o
l
l
a
r
i
z
a
t
i
o
n
r
a
t
i
o
(
i
n
p
e
r
c
e
n
t
)
1
/
4
(
I
n
p
e
r
c
e
n
t
p
e
r
a
n
n
u
m
,
u
n
l
e
s
s
o
t
h
e
r
w
i
s
e
i
n
d
i
c
a
t
e
d
)
T
u
r
k
e
y
:
M
a
c
r
o
e
c
o
n
o
m
i
c
I
n
d
i
c
a
t
o
r
s
,
1
9
8
7
9
6
2
.
7
b
F
i
g
u
r
e
49
F
i
g
u
r
e
2
.
7
c
T
u
r
k
e
y
:
M
a
c
r
o
e
c
o
n
o
m
i
c
I
n
d
i
c
a
t
o
r
s
,
1
9
8
7
9
6
(
I
n
p
e
r
c
e
n
t
p
e
r
a
n
n
u
m
,
u
n
l
e
s
s
o
t
h
e
r
w
i
s
e
i
n
d
i
c
a
t
e
d
)
1
0
0
D
o
m
e
s
t
i
c
T
o
t
a
l
g
o
v
e
r
n
m
e
n
t
d
e
b
t
(
i
n
p
e
r
c
e
n
t
o
f
G
D
P
;
l
e
f
t
s
c
a
l
e
)
E
x
t
e
r
n
a
l
8
0
{
M
a
t
u
r
i
t
y
o
f
b
o
r
r
o
w
i
n
g
2
/
(
i
n
d
a
y
s
;
r
i
g
h
t
s
c
a
l
e
)
3
0
0
9
0
0
0
0
E
x
c
h
a
n
g
e
r
a
t
e
s
3
/
1
3
0
R
e
a
l
e
f
f
e
c
t
i
v
e
e
x
c
h
a
n
g
e
r
a
t
e
(
1
9
9
0
=
1
0
0
;
r
i
g
h
t
s
c
a
l
e
)
2
5
0
1
2
0
6
0
0
0
0
6
0
2
0
0
1
1
0
4
0
3
0
0
0
0
1
5
0
2
0
1
0
0
L
i
r
a
s
p
e
r
U
S
d
o
l
l
a
r
(
l
e
f
t
s
c
a
l
e
)
0
1
0
0
0
9
0
1
9
8
8
1
9
9
0
1
9
9
2
1
9
9
4
1
9
9
6
1
9
8
8
1
9
9
0
1
9
9
2
1
9
9
4
1
9
9
6
S
o
u
r
c
e
:
I
n
t
e
r
n
a
t
i
o
n
a
l
M
o
n
e
t
a
r
y
F
u
n
d
a
n
d
o
f
f
i
c
i
a
l
e
s
t
i
m
a
t
e
s
.
2
/
N
e
w
l
y
i
s
s
u
e
d
d
e
b
t
.
3
/
A
r
i
s
e
i
s
a
d
e
p
r
e
c
i
a
t
i
o
n
.
50




Dollarization can thus be viewed as an endogenous
response by domestic agents attempting to avoid
the inflation tax and capital losses on assets
denominated in domestic-currency terms.
It also responds to portfolio diversification needs.
Even after sharp reductions in inflation, dollarization
can remain relatively high.
Reasons:
Guidotti and Rodriguez (1992) and Uribe
(1997b):
Transactions costs incurred in switching from one
currency to the other.
51




Reduction of the propensity to hold foreign currency
balances requires a very low inflation rate to induce
individuals to regain skills in the use of the domestic
currency.
McNelis and Rojas-Suarez (1996):
Degree of currency substitution depends not only
on expectations of inflation and exchange rate
depreciation, but also on the risk (or volatility)
associated with these variables.
In periods of low inflation (or poststabilization
episodes) risk factors become more important.
In Bolivia and Peru, depreciation risk is an
important factor in explaining the persistence of
dollarization in low inflation situation.
52




Dollarization is benefical, if it leads to an increase in
the flow of funds into the banking system.
High dollarization may complicate the conduct of
monetary and exchange rate policy.
Why?
Dollarization involves loss of seigniorage
revenue, because the demand for domestic base
money is lower.
Outcome may be inflationary spiral, since this loss
in revenue can lead to increased monetary
financing.
53



Dollarization affects the choice of assets that should
be included in the monetary aggregates (used as
indicators of monetary conditions or target
variables).
Dollarization (in the form of foreign currency
deposits in domestic banks): index bank deposits to
the exchange rate.
If loans extended against foreign-currency deposits
are denominated in domestic currency, the
currency mismatch may weaken banks' balance
sheets if the exchange rate depreciates.
54



Dollarization affects the choice of an exchange rate
regime, because it implies short-term foreigncurrency liabilities against which foreign exchange
reserves of the banking system must be measured.
Figure 2.8.
High degrees of dollarization are not a cause, but
rather a symptom, of underlying financial
imbalances and weaknesses.
55
F
i
g
u
r
e
2
.
8
a
F
o
r
e
i
g
n
C
u
r
r
e
n
c
y
D
e
p
o
s
i
t
s
i
n
t
h
e
D
o
m
e
s
t
i
c
B
a
n
k
i
n
g
S
y
s
t
e
m
(
I
n
p
r
o
p
o
r
t
i
o
n
o
f
t
o
t
a
l
f
o
r
e
i
g
n
r
e
s
e
r
v
e
s
m
i
n
u
s
g
o
l
d
)
350
140
Bo
300
120
250
100
200
80
150
60
100
40
50
20
0
0
1985q
1988
199
19
1985q1
1988q1
1991q1
1994q1
S
o
u
r
c
e
:
I
n
t
e
r
n
a
t
i
o
n
a
l
M
o
n
e
t
a
r
y
F
u
n
d
.
56
F
i
g
u
r
e
2
.
8
b
F
o
r
e
i
g
n
C
u
r
r
e
n
c
y
D
e
p
o
s
i
t
s
i
n
t
h
e
D
o
m
e
s
t
i
c
B
a
n
k
i
n
g
S
y
s
t
e
m
(
I
n
p
r
o
p
o
r
t
i
o
n
o
f
t
o
t
a
l
f
o
r
e
i
g
n
r
e
s
e
r
v
e
s
m
i
n
u
s
g
o
l
d
)
35
6
30
5
25
M e
4
20
3
15
10
5
2
1
0
0
11
9
1
9
8
1
9
8
5
9
9
8
q
1
9
1
q
1
1
9
4
q
1
1
9
8
q
1
1
9
8
5
1
9
9
8
q
S
o
u
r
c
e
:
I
n
t
e
r
n
a
t
i
o
n
a
l
M
o
n
e
t
a
r
y
F
u
n
d
.
57
F
i
g
u
r
e
2
.
8
c
F
o
r
e
i
g
n
C
u
r
r
e
n
c
y
D
e
p
o
s
i
t
s
i
n
t
h
e
D
o
m
e
s
t
i
c
B
a
n
k
i
n
g
S
y
s
t
e
m
(
I
n
p
r
o
p
o
r
t
i
o
n
o
f
t
o
t
a
l
f
o
r
e
i
g
n
r
e
s
e
r
v
e
s
m
i
n
u
s
g
o
l
d
)
25
8T
0 ur k
70
20
60
15
10
50
40
30
5
20
10
0
1
1
9
1
9
8
1
9
8
5
9
9
8
q
11
9
1
9
8
1
9
8
5
9
9
8
q
9
1
q
1
4
q
1
q
1
1
S
o
u
r
c
e
:
I
n
t
e
r
n
a
t
i
o
n
a
l
M
o
n
e
t
a
r
y
F
u
n
d
.
58
The Demand for Money
59


Stability of money demand is essential for the
conduct of monetary policy.
Real money balances:
md = md(y, i, , a, ),
y: level of transactions (positive sign expected);
i, , a : domestic nominal interest rate, domestic
inflation rate, rate of depreciation of nominal
exchange rate (degree of dollarization or currency
substitution).All measure the opportunity cost of
holding money.
: variability of inflation (proxy for macroeconomic
instability); negative effect is expected.
60





Choudhry (1995):
Focus on Argentina, Israel, Mexico (experienced
high inflation, large current account imbalances,
and drastic devaluation).
Find stable long-run money demand function.
Used both inflation rate and rate of currency
depreciation to measure the opportunity cost of
holding domestic money.
Results:
Significant currency substitution effect.
But relatively small compared with the direct effect
of inflation on money demand.
61


In other empirical studies: include measures of
financial innovation and development.
Financial liberalization: affect the relation between
money demand and its determinants and
complicate the conduct of monetary policy.
62