Currency substitution in Turkey

Although currency substitution is a widely observed phenomenon in both developed and developing countries, most of the studies on currency substitution in small open economies have focused on high inflation South American countries. This paper extends the previous analysis to a newly industrializing, high-inflation economy, namely Turkey. A vector autoregression model has been estimated employing the certain policy variables to investigate the dynamics of currency substitution in the economy. Dynamic impulse responses show that the residents have a preference for substituting foreign currencies for domestic currency because of real-exchange-rate depreciations. The results suggest that to stop or to reverse the on-going currency-substitution process a policy aiming to increase the expected real return on domestic assets should be adopted.