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Introducing Liability Dollarization and Contractionary Depreciations to the IS Curve

This paper presents a simple modification to the standard IS curve used, at least implicitly, by policymakers that allows capital flight to have a contractionary effect in emerging market economies. In the standard model, capital flight leads to an expansionary shift in the IS curve through an increase in net exports. However, in the presence of liability dollarization for domestic firms, a currency depreciation triggered by capital flight leads to an investment collapse. A simple adjustment to the standard investment schedule captures this channel and allows for the possibility that capital flight yields a contractionary shift in the IS curve.