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Currency substitution in the economies of Central Asia: how much does it cost?

Asel Isakova

No 14/2010, BOFIT Discussion Papers from Bank of Finland, Institute for Economies in Transition

Abstract: Underdeveloped financial markets and periods of high inflation have stimulated dollarization and currency substitution in the economies of Central Asia. Some authors argue that the latter can pose serious obstacles for the effective conduct of monetary policy and can affect households welfare.This study uses a model with money-in-the-utility function to estimate the elasticity of substitution between domestic and foreign currencies in three economies of Central Asia - Kazakhstan, the Kyrgyz Republic and Tajikistan. Utility derived from holding money balances is represented by a CES function with money holdings denominated in two currencies. The residents are assumed to diversify their monetary holdings due to instability of the domestic currency. The steady state analysis reveals that though currency substitution decreases governments seigniorage revenue, holding foreign money can be welfare generating if domestic currency depreciates vis-à-vis the currencies in which households foreign balances holdings are denominated. De-dollarization can only be achieved through further macroeconomic stabilization that will bring price and exchange rate stability. Financial sector development will also decrease currency substitution through the provision of reliable financial instruments and the gaining of public confidence.

Date: 2010-07-23
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Published in Published: Book chapter (pages 89-108) in Nowotny, E., Mooslechner, P., Ritzberger-Grünwald, D., The euro and economic stability: Focus on Central, Eastern and South-Eastern Europe, Edward Elgar, 2010.

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