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Currency Choice in Contracts

Author

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  • Andres Drenik
  • Rishabh Kirpalani
  • Diego J Perez

Abstract

We study the interaction between the currency choice of private domestic contracts and optimal monetary policy. The optimal currency choice depends on the price risk of each currency, as well as on the covariance of its price and the relative consumption needs of the agents signing the contract. When a larger share of contracts is denominated in local currency, the government can use inflation more effectively to either redistribute resources or reduce default costs, which makes local currency more attractive for private contracts. When governments lack commitment, competitive equilibria can be constrained inefficient, thus providing a reason to regulate the currency choice of private contracts. We show that both the equilibrium use of local currency and the implications for regulation depend on the level of domestic policy risk. Our model can explain the wide use of the US dollar in international trade contracts and the observed hysteresis in dollarization.

Suggested Citation

  • Andres Drenik & Rishabh Kirpalani & Diego J Perez, 2022. "Currency Choice in Contracts," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 89(5), pages 2529-2558.
    • Handle: RePEc:oup:restud:v:89:y:2022:i:5:p:2529-2558.
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    File URL: http://hdl.handle.net/10.1093/restud/rdab093
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    Cited by:

    1. Xie, Oliver, 2024. "Financial Hedging and Optimal Currency of Invoicing," SocArXiv v8zdk, Center for Open Science.
    2. Liu, Siming & Ma, Chang & Shen, Hewei, 2024. "Sudden stop with local currency debt," Journal of International Economics, Elsevier, vol. 148(C).

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