On liability dollarization: a simple model with financially closed and open economies

This paper presents a simple analysis of debt-denomination choice in small open economies, either financially isolated, or integrated in world credit markets. In the model, borrowers are producers of nontraded goods, the relative prices are subject to shocks. The nominal exchange rate is also random, subject to an exogenous (policy) shock.
Debt obligations can be denominated in units of traded goods (dollarized contracts) or in local currency. Default can occur, and it is costly to the contract parties. In a financially closed economy, the model implies that the choice of denomination depends on the probability of default with each contract, and on the value of the default cost. If real and nominal exchange rates are positively correlated, dollarized contracts tend to be preferred to (non-contingent) nominal contracts when real shocks are small and there is "excess volatility" in the nominal shock. When foreign risk-neutral investors are added to the model, in addition to the default properties, the choice of denomination also depends on the possibility of hedging relative-price risks o?ered by contracts to residents. The model does not reflect "home country bias": here, in equilibrium, domestic lenders invest their funds in the foreign bond, while local borrowers finance projects in the international market.