Financial Frictions and the Interest Rate Spread in a Dollarized Economy

This paper presents a partial-equilibrium characterization of the credit market in a partially dollarized economy. Financial frictions—in the form of verification costs and banking regulation—are introduced, and their impact on lending and deposit rates denominated in domestic and foreign currencies is examined. The results show that the effect of reserve requirements can be understood as a tax that leads banks to lower deposit rates, while the spread between lending rates in foreign and domestic currencies decreases with exchange rate volatility and increases with the degree of correlation between business returns and the exchange rate. (Audio: Department of Economic Publications)