Inflationary Finance, Capital Controls, and Currency Substitution

Ajay Tandon and Yong Wang ()

Review of International Economics, 1999, vol. 7, issue 4, 597-612

Abstract: This paper studies currency substitution in an environment where agents' inflation tax-evasive demand for foreign money is balanced by the concern for the possibility that the government may impose economy-wide capital controls under which foreign currency transactions are costly. Under the assumption of endogenous beliefs, the results show a persistent demand for foreign money despite efforts by the government to reduce inflation. In addition, the economy can exhibit multiple, Pareto-ranked steady states with different levels of currency substitution. The stability analysis suggests that the economy converges to the inferior steady state, on the "wrong side" of the Laffer curve. Copyright 1999 by Blackwell Publishing Ltd.

Date: 1999
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