Andres Drenik, Rishabh Kirpalani , Diego Perez
2019-06-06 - We study a model in which agents choose the currency in which to denominate contracts, and the government chooses the inflation rate. The optimal choice of currency trades-off the price risk of each currency with how this risk covaries with the relative consumption needs of the agents signing the contract. When a larger share of private contracts are denominated in local currency, the government can use inflation to redistribute resources more effectively within the economy which, in turn, makes local currency more attractive as a unit of account for private contracts. The use of local currency is more likely when there is low domestic policy risk. Consistent with recent policy initiatives, policies that encourage the denomination of contracts exclusively in local currency can be desirable, since private agents do not internalize the complementarities between private actions and those of the government. We also use our model to explain the wide use of the dollar in international trade contracts and the observed hysteresis of dollarization that occurred in several Latin American countries.