Shortage and Currency Substitution in Transition Economies: Bulgaria, Hungary, Poland, and Romania

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This paper examines currency substitution in Bulgaria, Hungary, Poland, and Romania during the end of central planning and transition to market economies. Before liberalization, central European economies faced increasing shortage and repressed inflation in the official sector. Households held substantial wealth in real assets and foreign currency. Furthermore, part of their savings was held as hunting money against potential opportunities to buy in bulk at bargain prices in official stores or pay a premium price on the black market. The shift from centrally-planned to market economies is modeled with a shortage variable. Foreign currency demand and consumption functions are estimated by the Johansen procedure. Environmental constraints play a key role in interpreting estimates. The official sector shortage is an important determinant of foreign currency demand in each country. (JEL F31, F41)


This paper examines currency substitution in four central European economies. Bulgaria, Hungary, Poland, and Romania, from 1986 to 1994. Currency substitution is an important concept in the history of economic thought. Menger [1874, pp. 268-70] cites the use of parallel exchange commodities in ancient Mexico during the transition from bartering to a monetary economy. Interestingly, currency substitution can therefore predate the establishment of money. Currency substitution is a necessary precondition for the action of Gresham's law which states that at least two currencies must circulate in parallel before one can drive out the other. Gresham's law describes an extreme case of currency substitution which results in abandonment of one of the currencies. In Gresham's law, the good money's superior store-of-value character leads to hoarding and the bad money's equal value for transactions leads to it being used for all transactions.

In centrally-planned economies (CPEs), currency substitution was a very singular phenomenon. Gresham's law never became fully operable because although foreign currency had a superior store-of-value character, both foreign and domestic currencies had separate, complementary transaction uses in official and nonofficial sectors. High levels of currency substitution accompanied high inflation and uncertainty.

Current literature provides significant coverage of currency substitution. The experience of the transition economies closely resembles the recent history of some Latin American countries, such as Argentina, Bolivia, Mexico, Peru, and Uruguay [Sahay and Vegh, 1995]. Currency substitution in Latin America has received a great deal of attention in literature (see for example, Calvo and Vegh [1992], Rodriguez [1992], Rojas-Suarez [1992], Savastano [1992], and Sturzenegger [1992]). Currency substitution in the transition economies of central and eastern Europe received much less attention, with the notable exceptions of Charemza and Ghatak [1990], van Aarle [1994], and van Aarle and Budina [1995].

Darrat and Al-Mutawa [1996] conclude that dollar-yen currency substitution must be included in a properly specified money demand function for Japan. This may result from significant U.S. government security holdings in Japanese portfolios, which has no symmetric counterpart in American investment behavior. Laopodis [1998] found no significant currency substitution in Greece, Portugal, or Spain.

The remainder of this paper is organized as follows. The second section presents the derivation of a currency substitution model of foreign money demand. The third section analyzes data for the four countries and presents shortage measures. The fourth section presents empirical estimates of the foreign money demand function derived in the second section. The fifth section summarizes the main points and draws conclusions.

Background and Theory

In the traditional view of CPEs as shortage economies [Kornai, 1980], central planning authorities arbitrarily divide the money stock between household and state enterprise sectors [Hartwig, 1983, 1985]. …