Currency Substitution: A Theoretical and Empirical Analysis for Germany and Europe

Franz Seitz and Hans-Eggert Reimers

Manchester School, 1999, vol. 67, issue 2, 137-153

Abstract: The deutschmark is the anchor currency within the asymmetrical functioning of the European Monetary System (EMS). Thus the proper functioning of the monetary targeting strategy of the Bundesbank is a necessary prerequisite of the success of the system. This strategy relies heavily on stable monetary relations. Because of the big weight of the German monetary aggregate in a European aggregate this stability also has very important repercussions for monetary policy of the future European System of Central Banks. Currency substitution (CS) relative to other European currencies may cause instability in the German money demand equation. Theoretically there are arguments in favour of and against CS in the EMS. Empirically this phenomenon is analysed for a German money demand equation for M3. CS effects are investigated by testing the significance of CS variables in the short‐run dynamics of an error correction mechanism. In most cases there are no significant CS effects. Exceptions are Italy and the European Union as a whole, where the weight of currencies which have frequently depreciated against the deutschmark is high.

Date: 1999
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