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The dynamics of inflation and currency substitution in a small open economy

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  • Miguel Lebre de Freitas

    ()
    (Departamento de Economia e Gestão Industrial, Universidade de Aveiro)

Abstract

In this paper, we analyse the relationship between money and inflation in a small open economy where domestic and foreign currencies are perfect substitutes as means of payment. It is shown that, if the path of domestic money supply is such that individuals find it optimal to change the currency in which transactions are settled, there will be an adjustment period during which domestic inflation adjusts so as to equalise the foreign inflation rate. In the case of a disinflation program, it is shown that the foreign currency is not necessarily abandoned as means of payment. The results obtained are consistent with both dollarisation hysteresis and reversibility, without requiring the specification of dollarisation costs.

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Bibliographic Info

Paper provided by Departamento de Economia, Gestão e Engenharia Industrial, Universidade de Aveiro in its series Working Papers de Economia (Economics Working Papers) with number 02.

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Length: 27 pages
Date of creation: Aug 2003
Date of revision: Aug 2003
Handle: RePEc:ave:wpaper:022003

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Keywords: currency substitution; dollarisation; money-demand and hysteresis;

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References

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  1. Martin Uribe, 1995. "Hysteresis in a simple model of currency substitution," International Finance Discussion Papers 509, Board of Governors of the Federal Reserve System (U.S.).
  2. Clements, Benedict & Schwartz, Gerd, 1993. "Currency substitution: The recent experience of Bolivia," World Development, Elsevier, vol. 21(11), pages 1883-1893, November.
  3. Kareken, John & Wallace, Neil, 1981. "On the Indeterminacy of Equilibrium Exchange Rates," The Quarterly Journal of Economics, MIT Press, vol. 96(2), pages 207-22, May.
  4. Dowd, Kevin & Greenaway, David, 1993. "Currency Competition, Network Externalities and Switching Costs: Towards an Alternative View of Optimum Currency Areas," Economic Journal, Royal Economic Society, vol. 103(420), pages 1180-89, September.
  5. Rudiger Dornbusch & Alejandro Reynoso, 1989. "Financial Factors in Economic Development," NBER Working Papers 2889, National Bureau of Economic Research, Inc.
  6. Chang, Roberto, 1994. "Endogenous Currency Substitution, Inflationary Finance, and Welfare," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 26(4), pages 903-16, November.
  7. Pablo Emilio Guidotti & Carlos A. Rodriguez, 1991. "Dollarization in Latin America - Gresham's Law in Reverse?," IMF Working Papers 91/117, International Monetary Fund.
  8. Federico A. Sturzenegger, 1992. "Inflation and Social Welfare in a Model with Endogenous Financial Adaptation," UCLA Economics Working Papers 658, UCLA Department of Economics.
  9. Federico Sturzenegger, 1992. "Inflation and Social Welfare in a Model With Endogenous Financial Adaptation," NBER Working Papers 4103, National Bureau of Economic Research, Inc.
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Citations

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Cited by:
  1. Yinusa, D. Olalekan, 2009. "Macroeconomic Fluctuations and Deposit Dollarization in Sub-Saharan Africa: Evidence from Panel Data," MPRA Paper 16259, University Library of Munich, Germany, revised 2009.
  2. Kyriakos C. Neanidis & Christos S. Savva, 2006. "The Effects of Uncertainty on Currency Substitution and Inflation: Evidence from Emerging Economies," The School of Economics Discussion Paper Series 0609, Economics, The University of Manchester.
  3. Miguel Lebre de Freitas, 2006. "Currency Substitution and Money Demand in Euroland," Atlantic Economic Journal, International Atlantic Economic Society, vol. 34(3), pages 275-287, September.
  4. Thomas Scheiber & Helmut Stix, 2009. "Euroization in Central, Eastern and Southeastern Europe – New Evidence On Its Extent and Some Evidence On Its Causes," Working Papers 159, Oesterreichische Nationalbank (Austrian Central Bank).
  5. Helmut Stix, 2008. "Euroization: What Factors drive its Persistence?," Working Papers 140, Oesterreichische Nationalbank (Austrian Central Bank).
  6. Miguel Lebre de Freitas & Francisco José Veiga, 2006. "Currency substitution, portfolio diversification, and money demand," Canadian Journal of Economics, Canadian Economics Association, vol. 39(3), pages 719-743, August.
  7. Edlira Narazani, 2013. "A Micro Level Perspective of Euroization in Albania," wiiw Balkan Observatory Working Papers 109, The Vienna Institute for International Economic Studies, wiiw.

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