Currency substitution and exchange rate determination

Yijian He and Subhash Sharma

Applied Financial Economics, 1997, vol. 7, issue 4, 327-336

Abstract: The objectives of this paper are twofold. First, the monetary exchange rate model of Frenkel-Bilson and Dornbusch-Frankel is extended to allow for the currency substitution between two countries, i.e. the domestic residents to hold the foreign money and the foreign residents to hold the domestic money. Second, by using the exchange rates from 1978.Q4 to 1991.Q2 between the US dollar and the Canadian dollar, US dollar and Japanese yen, US dollar and UK pound, and US dollar and German mark, we test if the new model is a long run exchange rate determination model and if currency substitution is a significant factor in influencing the long-run exchange rate. This is achieved by applying the techniques of cointegration and error correction analysis and the ten period out of sample forecasting performance of the extended model. In general, the US-Canada, US-Germany, US-Japan and US-UK extended models outperform the random walk model.

Date: 1997
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DOI: 10.1080/096031097333448

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