Currency substitution in high inflation countries : an empirical analysis

Abstract

This study explores the importance of currency substitution phenomena, encountered mostly in high inflation countries rather than other countries. First, it investigates the causes and consequences of currency substitution. It then employs a measure of the currency substitution to estimate the elasticity of substitution between two currencies; national and foreign currencies in a money-in-the-utility framework. The utility function of representative agents includes consumption and money services separately and is linear in consumption. Money services are produced by combining domestic and foreign real balances in Constant Elasticity of Substitution production function. The presence of money services in the utility function is to indicate the transaction costs reducing properties of the two currencies. Ten high inflation countries are analyzed for the empirical measurements. Assumed as small, open economies each of these countries is compared to the rest of the world represented by the United States. The shares of domestic and foreign real balances, the discount factors, the shares of money services in the utility functions and the elasticities of substitution are directly estimated by Hansen’s Generalized Method of Moments procedure. The fact that inflation reduces the credibility of domestic currency leads to high elasticity of substitution between two currencies in the market of high inflation countries. In other words, the public is vulnerable to the changes in the relative prices while deciding their money allocations and currency substitution is of first-order importance in these countries.