Currency Substitution, Capital Flight and Real Exchange Rates
This paper focuses on a monetary explanation of real exchange rate fluctuations, namely capital flight provoked by the process of currency substitution. Under fixed exchange rates, capital inflows to reconstitute domestic money holdings produce a positive liquidity effect due to the creation of inside money by the financial system. This can initially lead to an exchange rate appreciation, through an increase in the price of nontradables, and a current account deficit. A process of deflation must then ensue to converge to the new steady state equilibrium.
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