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This paper was prepared as the introductory chapter for a special issue, edited by the authors, on “Currency Substitution in Developing Countries” of the Revista de Análisis Económico, to be published in June 1992. The authors are grateful to José De Gregorio, Pablo Guidotti, Leonardo Leiderman, Nissan Liviatan, Carmen Reinhart, Liliana Rojas-Suarez, and Peter Wickham for insightful comments and discussions. The views expressed in this paper are those of the authors and do not necessarily reflect those of the International Monetary Fund.
We abstract, therefore, from the vast literature that followed McKinnon’s (1982) important contribution arguing in favor of focusing on world, as opposed to national, monetary aggregates. We also abstract from currency-substitution issues related to the EMS (see Giovannini (1990) for a discussion). Even with respect to currency substitution in developing countries, this review is not intended to be comprehensive. The paper reflects our own views on what issues are important, and how they should be approached.
Hence, an economy in which the foreign currency serves only as unit of account and/or store of value is dollarized, but is not subject to currency substitution. Sachs (1986) argues that this was the case in Bolivia.
See Bernholz (1989) for a discussion of historical episodes in which a secondary currency replaced the primary currency as a result of high inflation.
Drazen and Helpman (1990) conclude that there may be lack of contemporaneous correlation between fiscal deficits and inflation even when the budget deficit is clearly the ultimate cause of inflation.
The observations made in this paragraph are based on casual evidence and may vary from country to country. We are not aware of any evidence that documents the dynamics whereby a foreign currency displaces the domestic currency. This is certainly a fascinating, but rather unexplored, issue which lies at the core of monetary theory.
In hyperinflationary conditions, almost all prices are quoted in (i.e., indexed) to foreign currency, as argued by Sachs (1986) for the Bolivian hyperinflation. Interestingly, however, Sachs (1986) claims that dollarization stopped short of actual transactions in U.S. dollars. In contrast, Sargent (1982) argues that, in the German hyperinflation, large amounts of foreign currency were held for transactions purposes.
Theory suggests, and evidence in high-inflation countries seems to confirm, that money-based stabilization leads to an initial recession, while exchange-rate-based stabilization leads to an initial boom and later recession (see Calvo and Végh (1990a) and Kiguel and Liviatan (1991)).
The recent money-based stabilization in Peru which led to a sharp real exchange rate appreciation has brought this issue to the forefront once again.
Money in Panama comprises U.S. notes and coin, Panamanian coin, and demand deposits. However, the amount of Panamanian coin in circulation is negligible in comparison to U.S. currency. High inflation is certainly not a problem in Panama. The average annual inflation rate from 1981 to 1990 was 1.8 percent. By comparison, the average annual inflation rate in the United States from 1981 to 1990 was 4.7 percent. (Data from International Financial Statistics.)
Liberia had the same dollar-based monetary system as Panama until the mid-1980’s. At that time, political upheaval and budget deficits led the government to issue large amount of five-dollar coins (and then, in 1989, five-dollar notes). As a result, U.S. banknotes have disappeared from circulation and the Liberian dollar has become the medium of exchange. (Since 1985, the Liberian dollar has been traded at a discount with respect to the U.S. dollar in the parallel market.) Liberia thus provides a fascinating modern-day application of Gresham’s law.
Actually, domestic debt may serve as a way of reneging on full dollarization. This would happen if, say, the government paid wages and salaries with its own paper, forcing it to become a medium of exchange.
See Frenkel (1982) for a discussion of the “discipline” argument in the context of fixed versus flexible exchange rates. Canzoneri and Diba (1991) examine whether currency substitution imposes inflation “discipline” in the context of the EMS.
Calvo and Végh (1990b, 1990c) study the effectiveness of interest rate policy--modeled as paying interest on money--in fighting high inflation. Sustainability issues related to such policies are discussed in Calvo (1992) (see also Fernandez (1991)). Dornbusch and Reynoso (1989) are equally skeptical of high interest rates as a substitute for fiscal correction. Based on the Brazilian case, they argue that the steady accumulation of public debt that pays high interest rates leads to a situation in which the entire public debt is matched by interest-bearing, checkable deposits. Eventually, the government will be unable to roll over its debt, and a funding crisis will arise. See also Dornbusch, Sturzenegger and Wolf (1990).
The banking system becomes vulnerable essentially when there is a mismatching of assets and liabilities in terms of currency or maturity. In the euromarkets, the extent to which banks can have a net imbalance in foreign currency terms has been subject to review by the supervisory authorities.
An example may help to clarify the central issue. Suppose the U.S. government erased the number “10” from the 10-dollar bills, and let the market determine the price of the ex-10-dollar bills (i.e., their exchange rate) against all the other dollar bills. A moment’s reflection shows that, given an exchange rate, total money supply is determined which, in turn, determines the price level. But if such exchange rate doubles, the price level will increase to a new equilibrium. Hence, the exchange rate and the price level are totally undetermined--the system has no nominal anchor.
If there is lack of credibility, an early deceleration of inflation is more likely under exchange-rate-based stabilization, because the exchange rate “anchors” the price of traded goods.
Of course, the sustainability of fixed exchange rates depends on the level of available reserves. This is an issue that falls outside the scope of this paper. However, it is worth mentioning that, if the stabilization program is sound, and does not require substantial depletion of international reserves, fixed rates could be sustained by a “stabilization fund” like that recently granted to Poland and other previously centrally-planned economies.
Since the stock of foreign currency circulating in an economy is difficult to measure, there is no alternative but to rely on dollarization ratios (the proportion of M2 denominated in foreign currency). This discussion assumes that hysteresis in these dollarization ratios is a good indicator of hysteresis in currency substitution, which is far from clear (see the discussion in Section VI on asset substitution versus currency substitution).
They base their conclusions on a data set consisting of the record of informal loans in the Cochabamba region of Bolivia. The pattern of dollarization is measured by the currency of denomination of informal loans.
Liviatan (1981) assumed that the utility function is separable between consumption and liquidity services.
Specifically, the elasticity of substitution between the two currencies is higher than the elasticity of substitution between consumption and liquidity services.
The traditional results could be obtained even in the presence of a “pure” bond and flexible prices if, say, idiosyncratic shocks to foreign assets were introduced. Then, foreign currency would be hold also for portfolio considerations, as in the traditional formulations.
It is worth noting that some inflation instability may actually be desirable. Calvo and Guidotti (1992) show an example in which it is optimal to cover the unanticipated part of government expenditure through seignorage, even when the latter policy may create large inflation volatility.
While the use of the word “optimal” carries a normative connotation, one could also interpret these public finance results in terms of positive analysis; that is, as providing an explanation as to why governments engage in inflationary finance. Other explanations include the presence of collection costs (Aizenman (1987) and Végh (1989c)) and untaxable sectors (Canzoneri and Rogers (1990), Mourmouras (1991) and Mourmouras and Tijerina (1992)).
Note that the Diamond and Mirlees (1971) proposition--which states that it is not optimal to tax intermediate inputs in order for productive efficiency to be achieved--does not hold in Végh (1989a), in spite of the fact that money acts as an intermediate good. The reason, as argued by Guidotti and Végh (1990), is that, when transactions costs depend positively on consumption and negatively on real money balances, consumption acts both as a final and an intermediate good, thus rendering invalid the application of the Diamond and Mirlees (1971) proposition, except under special cases.
Imperfect substitutability has been modeled in various ways. The most common is probably to include both monies in the utility function (see, among many others, Liviatan (1981), Calvo (1985), Végh (1988), and Rogers (1990)). Alternative approaches include modeling currency substitution in a Baumol-Tobin context (see Poloz (1984) and Guidotti (1989)); assuming that both monies reduce transactions costs or shopping time (see Thomas (1985) and Végh (1989a, b)); and using a “liquidity-in-advance” constraint (see Calvo and Végh (1990a) and Rojas (1990)).
The econometric evidence for Latin American countries, in particular, is extensive. On Argentina, see Canto and Nickelsburg (1987), Fasano-Filho (1987), and Ramirez-Rojas (1985). On Bolivia, see Clements and Schwartz (1992), Melvin (1988), Melvin and Afcha (1989), Melvin and Ladman (1991), Melvin and Fenske (1992), and Savastano (1992). On Brazil, see Calomiris and Domowitz (1989). On Ecuador, see Canto and Nickelsburg (1987). On Mexico, see Melvin (1988), Ortiz (1983a, b) and Savastano (1992). On Peru, see Rojas-Suarez (1992) and Savastano (1992). On Uruguay, see Ramirez-Rojas (1985) and Savastano (1992). On Venezuela, see Canto and Nickelsburg (1987) and Márquez (1987). In addition, El-Erian (1988) studies the case of Egypt and the Yemen Arab Republic, and Agénor and Khan (1992) study dollarization in ten developing countries (Bangladesh, Brazil, Ecuador, Indonesia, Malaysia, Mexico, Morocco, Nigeria, Pakistan, and Philippines). Stanczak (1989) describes the Polish experience.
An exception to the use of foreign-currency deposits is found in Melvin and Fenske (1992). They use data on loans denominated on both domestic and foreign currency to test a model of lender behavior.
Since these accounts have basically a required reserve ratio of 100 percent, they can be viewed as foreign currency deposits.
See Melvin and de la Parra (1989) for an attempt to estimate the stock of American dollars circulating in Bolivia.
The specification in (1) assumes that both nominal interest rates are known a priori. Otherwise, expected values and covariances between the marginal utility of consumption and nominal returns would enter equation (1).
As emphasized by Thomas (1985), portfolio considerations are irrelevant for currency substitution in the presence of perfect capital mobility, because foreign currency holdings are independent of asset composition. Increases in the demand for foreign currency will be financed by foreign borrowing without altering the share of foreign-currency-denominated assets in the consumer’s portfolio.
This is the standard assumption in currency substitution models. However, if foreign currency were used more heavily for a subset of goods (i.e., big-ticket items), then relative expenditure shares would enter equation (1) (see Sturzenegger (1991)).
Note that these results are consistent with the idea, discussed above, that demands for M2 may be capturing asset substitution rather than currency substitution.
In Argentina, GARCH statistics are significant for the parallel exchange rate but not for the inflation rate.