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Currency substitution in the economies of Central Asia: How much does it cost?

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  • ISAKOVA, Asel

    ()
    (CERGE-EI, 11121 Praha 1, Czech Republic)

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    Abstract

    Underdeveloped financial markets and periods of high inflation have stimulated dollarization and currency substitution in the economies of Central Asia. Some authors argue that the latter can pose serious obstacles for the effective conduct of monetary policy and can affect households' welfare. This study uses a model with money-in-the-utility function to estimate the elasticity of substitution between domestic and foreign currencies in three economies of Central Asia - Kazakhstan, the Kyrgyz Republic and Tajikistan. Utility derived from holding money balances is represented by a CES function with money holdings denominated in two currencies. The residents are assumed to diversify their monetary holdings due to instability of the domestic currency. The steady state analysis reveals that though currency substitution decreases governments' seigniorage revenue, holding foreign money can be welfare generating if domestic currency depreciates vis-à-vis the currencies in which households' foreign balances holdings are denominated. De-dollarization can only be achieved through further macroeconomic stabilization that will bring price and exchange rate stability. Financial sector development will also decrease currency substitution through the provision of reliable financial instruments and the gaining of public confidence.

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    File URL: http://www.uclouvain.be/cps/ucl/doc/core/documents/coredp2010_14web.pdf
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    Paper provided by Université catholique de Louvain, Center for Operations Research and Econometrics (CORE) in its series CORE Discussion Papers with number 2010014.

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    Date of creation: 01 Apr 2010
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    Handle: RePEc:cor:louvco:2010014

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    Keywords: currency substitution; dollarization; monetary policy; seigniorage; welfare; transition economies;

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