Academic journal article Economic Inquiry

International Currency Substitution and Seigniorage in a Simple Model of Money

Academic journal article Economic Inquiry

International Currency Substitution and Seigniorage in a Simple Model of Money

Article excerpt

I. INTRODUCTION

Currency substitution describes the change in the holdings of domestic and foreign real balances in response to fluctuations in the relative prices of these currencies. So far, the empirical evidence on the strength of currency substitution has been mixed. Miles [1978] finds evidence in favor of strong currency substitution between the Canadian dollar and the U.S. dollar. Bordo and Choudhri [1982] criticize Miles on the ground that Miles has a misspecified model and their estimates of a Canadian money demand function indicate little currency substitution. In a recent paper, Rogers [1992] finds that dollarization in a high-inflation economy such as Mexico's is quite strong and statistically significant. Imrohoroglu [1994], on the other hand, estimates the extent of currency substitution between the Canadian dollar and the U.S. dollar using a GMM approach and finds that the elasticity of currency substitution in Canada is quite low; between -0.29 and -0.43, depending on the instruments used. Furthermore, the estimate of the share of U.S. dollar-denominated deposits in producing Canadian liquidity services is on the order of 1 percent to 3 percent.

The policy implications of currency substitution have been extensively analyzed. Most of these studies concentrate on the impact of currency substitution on the volatility of exchange rates and the autonomy of domestic monetary policy under a flexible exchange rate regime.(1) Recently, researchers have started to explore whether currency substitution alters the results in the optimal inflation tax literature. For example, Vegh [1989] shows that it may be optimal to resort to the inflation tax under currency substitution since it reduces the distortion introduced by an exogenously given positive foreign interest rate. In his model, a positive foreign interest rate creates a distortion because it acts as an indirect consumption tax. Kimbrough [1991] analyzes a small, open economy under currency substitution where domestic agents are required to use domestic real balances to purchase the domestic nontraded good, foreign real balances to purchase the imported good, and either domestic or foreign real balances to purchase the exportable good. He finds that it is optimal to follow the Friedman Rule of a zero nominal interest rate in this setup since money serves as an intermediate good. Guidotti and Vegh [1993], however, argue that Kimbrough's [1991] result only applies under very restrictive assumptions on the transactions technology and that in general the optimal inflation rate is positive under currency substitution. Aizenman [1992] considers a multi-country money-in-the-utility-function model in a common currency area where there are collection costs associated with income taxation. He shows that in the absence of a cartel agreement on how to share the seigniorage revenue, the optimal inflation rate for individual countries will exceed the optimal inflation rate under a cooperative solution. Canzoneri and Diba [1992] study the role of currency substitution in a two-country money-in-the-utility-function model under a flexible exchange rate regime where there are collection costs of lump-sum taxes. They show that the outcome of a noncooperative seigniorage maximization or welfare maximization game is characterized by the Friedman Rule. The cooperative outcome, on the other hand, includes the inflation tax as part of an optimal tax package since lump-sum taxes are costly to collect.

The theoretical literature summarized above suggests that currency substitution may have important economic implications. Most of the attention has been on the role of the elasticity of currency substitution. The share of foreign real balances in the residents' domestic portfolio has largely been ignored. Laney, Radcliffe and Willett [1984] and Joines [1985] emphasize the distinction between the elasticity of substitution and the cross-elasticity of money demand and argue that a high cross-elasticity is necessary for currency substitution to have a major destabilizing impact on domestic money demand. …

Search by... Author
Show... All Results Primary Sources Peer-reviewed

Oops!

An unknown error has occurred. Please click the button below to reload the page. If the problem persists, please try again in a little while.