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Currency Substitution, Foreign Inflation, and Terms-of-Trade Dynamics

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  • Chen, Chau-nan
  • Tsaur, Tien-wang
  • Liu, Shun-chieh

Abstract

This paper incorporates rational expectations, full price flexibility, and currency substitution into the usual small-economy model, taking explicit account of inflation abroad. Not only will the steady-state terms of trade be affected by an increase in the rate of monetary expansion when the inflation rate abroad is assumed to be nonzero, but its dynamic path may also be different from the usual case in which inflation abroad is ignored. It has been shown that if the import demands are relatively inelastic, the terms of trade will undershoot their equilibrium value; if the import demands are elastic, the terms of trade will overshoot. The key to these diametrically opposite results is the degree of ultimate deterioration in the terms of trade. Copyright 1989 by University of Chicago Press.

Suggested Citation

  • Chen, Chau-nan & Tsaur, Tien-wang & Liu, Shun-chieh, 1989. "Currency Substitution, Foreign Inflation, and Terms-of-Trade Dynamics," Journal of Political Economy, University of Chicago Press, vol. 97(4), pages 955-964, August.
    • Handle: RePEc:ucp:jpolec:v:97:y:1989:i:4:p:955-64
    DOI: 10.1086/261635
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    Cited by:

    1. Chen, Shikuan, 1999. "Complex Dynamics of the Real Exchange Rate in an Open Macroeconomic Model," Journal of Macroeconomics, Elsevier, vol. 21(3), pages 493-508, July.
    2. Chen, Shikuan, 2000. "Endogenous real exchange rate fluctuations in an optimizing open economy model," Journal of International Money and Finance, Elsevier, vol. 19(2), pages 185-205, April.
    3. Madison, Florian, 2024. "A microfounded approach to currency substitution and government policy," Journal of Economic Theory, Elsevier, vol. 219(C).

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