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The Dynamics of Inflation and Currency Substitution in a Small Open Economy

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  • Miguel Lebre de Freitas

    ()
    (Universidade de Aveiro and NIPE)

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 NIPE - Universidade do Minho in its series NIPE Working Papers with number 1/2004.

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Date of creation: 2004
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Handle: RePEc:nip:nipewp:1/2004

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

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  1. Clements, Benedict & Schwartz, Gerd, 1993. "Currency substitution: The recent experience of Bolivia," World Development, Elsevier, vol. 21(11), pages 1883-1893, November.
  2. Pablo E. Guidotti & Carlos A. Rodriguez, 1992. "Dollarization in Latin America: Gresham's Law in Reverse?," IMF Staff Papers, Palgrave Macmillan, vol. 39(3), pages 518-544, September.
  3. Rudiger Dornbusch & Alejandro Reynoso, 1989. "Financial Factors in Economic Development," NBER Working Papers 2889, National Bureau of Economic Research, Inc.
  4. Federico Sturzenegger, 1992. "Inflation and Social Welfare in a Model With Endogenous Financial Adaptation," NBER Working Papers 4103, National Bureau of Economic Research, Inc.
  5. Chang, Roberto, 1989. "Endogenous Currency Substitution, Inflationary Finance, And Welfare," Working Papers 89-12, C.V. Starr Center for Applied Economics, New York University.
  6. 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.
  7. 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.).
  8. 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.
  9. Federico A. Sturzenegger, 1992. "Inflation and Social Welfare in a Model with Endogenous Financial Adaptation," UCLA Economics Working Papers 658, UCLA Department of Economics.
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Cited by:
  1. 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.
  2. Stix, Helmut, 2008. "Euroization: What Factors drive its Persistence?," Working Papers 140, Oesterreichische Nationalbank (Austrian Central Bank).
  3. 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.
  4. Miguel Lebre de Freitas, 2004. "Currency Substitution, portfolio Diversification and Money Demand," NIPE Working Papers 9/2004, NIPE - Universidade do Minho.
  5. 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.
  6. Stix, Helmut & Scheiber, Thomas, 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).

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