“Currency Substitution and Inflation in Peru”

The IMF Working Papers series is designed to make IMF staff research available to a wide audience. Almost 300 Working Papers are released each year, covering a wide range of theoretical and analytical topics, including balance of payments, monetary and fiscal issues, global liquidity, and national and international economic developments.

Abstract

The IMF Working Papers series is designed to make IMF staff research available to a wide audience. Almost 300 Working Papers are released each year, covering a wide range of theoretical and analytical topics, including balance of payments, monetary and fiscal issues, global liquidity, and national and international economic developments.

This paper deals with dollarization and its role in the dynamics of inflation in Peru from January 1978 through December 1990.

The paper uses an error-correction model to show that a long-run relationship exists between the expected rate of depreciation in the black market exchange rate and the ratio of domestic money to an indicator of holdings of U.S. dollars; that is, the hypothesis of currency substitution can explain the behavior of real holdings of money in Peru.

The paper also shows that the importance of currency substitution as a transmission mechanism through which domestic fiscal and monetary policies affected the short-run behavior of inflation varied during the period under study. In fact, the estimation of a dynamic equation for inflation suggests that while the importance of the mechanism was relatively small during the period of high but relatively stable inflation (January 1978-85), currency substitution became more important during Peru’s recent hyperinflation. The paper then highlights the policy implications derived from the empirical results.

Working Paper Summaries (WP/92/1 - WP/92/47)
Author: International Monetary Fund