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Must Original Sin Cause Macroeconomic Damnation?

Must Original Sin Cause Macroeconomic Damnation?

(p.48) 2 Must Original Sin Cause Macroeconomic Damnation?
Other People's Money
Luis Felipe Céspedes, Roberto Chang, AndrCés Velasco
University of Chicago Press

This chapter develops a simple general equilibrium open-economy model in which real exchange rates play a central role in the adjustment process, wages and prices are sticky in terms of domestic currency, liabilities are dollarized, and the country risk premium is endogenously determined by the net worth of domestic entrepreneurs. Hence, all the basic building blocks are there for unexpected real exchange rate movements to be financially dangerous under original sin. In spite of the model's apparent complexity, it obtains an analytic solution for all variables of interest, which can be depicted in terms of three familiar schedules: the IS and the LM, which correspond to equilibrium conditions in the goods and money market, and the BP, along which the international loan market is in equilibrium. This characterization helps to identify exactly how the combination of balance-sheet effects and liability dollarization may lead to departures from the standard framework.

Keywords:   exchange rates, domestic currency, risk premium, schedules, original sin, balance-sheet effects, liability dollarization, wages, prices, open-economy model

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