This paper expands the Cole and Kehoe (1996) model of debt crisis, by bringing in local currency. In the modified version, the government holds, not only debt instruments denominated in foreign currency, but also carries debt instruments in local currency. Under some circumstances, the partial default on the debt denominated in local currency makes way for the establishment of a central bank that is subject to political pressures from its government and that decides to devalue the local currency even though there is no speculative attack on the external debt. By using this model for an economy with local currency and a central bank that may be under political pressure, it is possible to compare the welfare levels between this economy and the one from original Cole-Kohoe models, which portrays a dollarized economy. Simulations are done for the Brazilian economy for June 1999 until May 2001. However, we should be careful when interpreting the results, since the numerical exercises suppose strong hypothesis to overcome the dimensionality problem.
