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Why Do Countries Borrow the Way They Borrow?

Why Do Countries Borrow the Way They Borrow?

(p.218) 8 Why Do Countries Borrow the Way They Borrow?
Other People's Money
Marcos Chamon, Ricardo Hausmann
University of Chicago Press

This chapter explores the interplay between an individual borrower's choices for liability denomination through their effect on the optimal monetary response of the central bank, given those choices. It starts from the assumption that the debt in domestic currency cannot be contracted at long maturities and at fixed rates. As a result, the terms in which it is rolled over or repriced will depend on changes in the domestic interest rate. The chapter explains why the absence of a domestic long-term market may preclude the ability to borrow in local currency, but not why big problems persist even in the presence of long-term domestic markets. In the chapter, there is a shock to the expected future exchange rate. Since agents are forward looking, that shock affects the present interest and exchange rates. The central bank uses monetary policy to determine how the absorption of that shock is divided between changes in the interest rate and in the exchange rate.

Keywords:   liability denomination, optimal monetary response, domestic interest rate, long-term market, original sin, domestic markets, exchange rate, monetary policy, interest rate

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