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The Real Effects of Foreign Inflation in the Presence of Currency Substitution

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  • Charles Engel

Abstract

The paper explores optimizing models of small open economies that hold foreign money balances. Particular attention is paid to the impact of foreign inflation on the real exchange rate and other real variables. At first, an environment in which foreign money is the only traded asset is explored. This is compared to a more general setting in which many assets can be traded. The effect of foreign inflation on domestic real variables depends on: 1) the degree to which it causes a substitution out of traded assets as a whole and into non-traded assets, and 2) the change in real returns on the portfolio of traded assets held by domestic residents.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 2140.

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Date of creation: Jan 1987
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Publication status: published as Journal of International Money and Finance, Volume 8, March 1989 "The Trade Balance and the Real Exchange Rate under Currency Substitution pp. 47-58
Handle: RePEc:nbr:nberwo:2140

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  1. Feenstra, Robert C., 1986. "Functional equivalence between liquidity costs and the utility of money," Journal of Monetary Economics, Elsevier, vol. 17(2), pages 271-291, March.
  2. Liviatan, Nissan, 1981. "Monetary Expansion and Real Exchange Rate Dynamics," Journal of Political Economy, University of Chicago Press, vol. 89(6), pages 1218-27, December.
  3. Daniel, Betty C., 1985. "Monetary autonomy and exchange rate dynamics under currency substitution," Journal of International Economics, Elsevier, vol. 19(1-2), pages 119-139, August.
  4. Helpman, Elhanan, 1981. "An Exploration in the Theory of Exchange-Rate Regimes," Scholarly Articles 3445091, Harvard University Department of Economics.
  5. Calvo, Guillermo A., 1985. "Currency substitution and the real exchange rate: the utility maximization approach," Journal of International Money and Finance, Elsevier, vol. 4(2), pages 175-188, June.
  6. Helpman, Elhanan & Razin, Assaf, 1982. "Dynamics of a Floating Exchange Rate Regime," Journal of Political Economy, University of Chicago Press, vol. 90(4), pages 728-54, August.
  7. Maurice Obstfeld, 1980. "Macroeconomic Policy, Exchange-Rate Dynamics, and Optimal Asset Accumulation," NBER Working Papers 0599, National Bureau of Economic Research, Inc.
  8. Paul R. Krugman, 1979. "Vehicle Currencies And the Structure Of International Exchange," NBER Working Papers 0333, National Bureau of Economic Research, Inc.
  9. Svensson, Lars E. O., 1985. "Currency prices, terms of trade, and interest rates: A general equilibrium asset-pricing cash-in-advance approach," Journal of International Economics, Elsevier, vol. 18(1-2), pages 17-41, February.
  10. Calvo, Guillermo A & Rodriguez, Carlos Alfredo, 1977. "A Model of Exchange Rate Determination under Currency Substitution and Rational Expectations," Journal of Political Economy, University of Chicago Press, vol. 85(3), pages 617-25, June.
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