Expectations, Credibility, and the Persistence of Currency Substitution

This study examines why currency substitution proves so difficult to reverse, even after countries succeed in stabilizing inflation. Focusing on Bolivia, Brazil, Mexico, and Turkey—economies that endured severe inflationary episodes before implementing stabilization programs—the paper asks a simple but important question: why does reliance on foreign currency persist long after inflation has been brought down? To answer this, the analysis adopts a structural time-series state-space framework that allows behavioral parameters to evolve gradually over time. Rather than assuming persistence, the model lets it emerge from the data and, crucially, compares alternative ways in which agents might form expectations about exchange rate movements. The evidence reveals a consistent pattern. By the end of the sample period, currency substitution remains statistically and economically significant in all four countries. The dominant expectation mechanism is extrapolative: agents tend to look at recent depreciation and assume it will continue. This tendency creates a reinforcing loop—when currencies depreciate, expectations of further depreciation strengthen, and the incentive to hold foreign currency intensifies. What makes these findings particularly striking is that this dynamic does not vanish once inflation is stabilized. Even in periods of relative macroeconomic calm, substitution persists. Past instability leaves a lasting imprint on expectations, and concerns about the durability of policy reforms continue to shape monetary behavior. In several cases, ongoing depreciation against the U.S. dollar further validates these cautious beliefs. As a result, the findings suggest that currency substitution is not merely a mechanical residue of past inflation. It is sustained by the way people form and update expectations in environments marked by credibility challenges. Stabilizing inflation is therefore a necessary step, but it is not enough on its own. Durable confidence in the domestic currency requires rebuilding credibility in a way that gradually reshapes expectations and restores trust over time.