The Demand for Currency Substitution

Abstract

A transactions model of the demand for multiple media of exchange is developed and applied to the study of currency substitution. The analysis provides a theoretical foundation for results reported in the empirical literature. Some results are expected, such as the dependence of currency substitution on the rates of return on the various currencies. Other results are both new and surprising. There are both extensive and intensive margins to currency substitution, and inflation may affect the two margins differently, leading to subtle incentives to adopt or abandon a substitute currency. Also, variables not previously considered in the literature affect currency substitution in complex and somewhat unexpected ways. In particular, the level of income and the composition of consumption expenditures are important, and they interact with the other variables in the model. The theory gives guidance on what data needs to be collected to conduct tests of the derived implications.

Keywords: Currency substitution, Dollarization

JEL Classification: E41, E42, E31