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Intertemporal substitution in a monetary framework : evidence from Chile and Mexico

  • Arrau, Patricio
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    This paper estimates a monetary Euler system of a utility-maximizing representative consumer from two inflationary Latin American countries: Chile in the late seventies and Mexico in the early eighties. The results show that money is necessary to get reasonable parameters of the utility function. For both countries, tests of the overidentifying restrictions are satisfactory at usual levels of significance and estimates for the intertemporal elasticity of substitution are greater than one. The results indicate that velocity sensitivity to the nominal interest rate is lower for Chile than for Mexico, but this difference could be explained by a model of currency substitution. More important, a model of currency substitution may be the appropriate way to explain the monetary puzzle observed in Mexico after the stabilization attempt of late 1987. Despite the fact that inflation was sharply (and permanently) reduced, velocity did not go down. The model of currency substitution suggests that a good way to hedge against discrete devaluation would be to increase liquidity in foreign - not domestic - currency.

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    Paper provided by The World Bank in its series Policy Research Working Paper Series with number 549.

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    Date of creation: 31 Dec 1990
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    Handle: RePEc:wbk:wbrwps:549
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    1. 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.
    2. Bernanke, Ben, 1985. "Adjustment costs, durables, and aggregate consumption," Journal of Monetary Economics, Elsevier, vol. 15(1), pages 41-68, January.
    3. Calvo, Guillermo A, 1986. "Temporary Stabilization: Predetermined Exchange Rates," Journal of Political Economy, University of Chicago Press, vol. 94(6), pages 1319-29, December.
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