Recent Experiences with Currency Substitution

Hisao Kumamoto

International Journal of Financial Research, 2014, vol. 5, issue 4, 1-12

Abstract: We empirically investigate recent experiences with currency substitution. We focus especially on the determinants of currency substitution, namely, the factors representing the usefulness of a foreign currency both as a medium of exchange and a store of value. This paper has three key distinguishing features. First, our sample includes eight developing and/or emerging countries from different regions to permit direct cross-country comparison, unlike in many previous studies. Second, this study covers a recent sample period. The U.S. dollar and the euro have been depreciating against other currencies since the 2007 financial crisis, and have therefore become less useful as a store of value. Therefore, it is important that we investigate whether the determinants of currency substitution have changed in recent periods. Third, we derive an estimated equation from the agent¡¯s utility maximization problem. In particular, we introduce the exchange rate risk premium as an alternative determinant, considering its relevance to the forward premium puzzle¡ªthe failure of the interest rate differential to correctly represent expected changes in the nominal exchange rate and hence the usefulness of foreign currency as a store of value. The empirical results indicate that the variables representing the usefulness of foreign currency both as a medium of exchange and a store of value are significant determinants of currency substitution. The results show that currency substitution has important monetary policy implications.

Keywords: currency substitution; network externalities; ratchet effects; foreign currency; domestic currency; euro (search for similar items in EconPapers)
Date: 2014
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