While many use the term `currency substitution' loosely to include `currency substitutability', or agents' ability and willingness to use different currencies, it is properly defined as the equilibrium outcome of one currency replacing another. In Discussion Paper No. 759, Programme Director Alberto Giovannini and Bart Turtelboom review the theoretical and empirical literature and illustrate the causes of substitutability for different currencies. They use cash-in-advance and transactions-costs models to consider the determinants of currency substitutability, distinguishing money's traditional functions as a unit of account, provider of transactions services and store of value.

The cash-in-advance model illustrates some basic issues in substitutability but cannot explain how different monies serve as stores of value. In the transaction-costs model, demands for domestic and foreign currencies are determined by their expected liquidity services, which highlights the determinants of their demand as stores of value, although these are difficult to identify empirically. For countries whose underdeveloped financial markets impede the purchase and sale of assets by individuals, such liquidity services and the demand for money as a store of value both rise. If a domestic currency has low expected returns, the foreign currency becomes a significant liquid investment.

Giovannini and Turtelboom report that numerous data problems impede the measurement of currency substitution. This is often understood as substitutability as a means of exchange which should ideally include foreign banknotes in circulation and residents' checking accounts and short-term deposits denominated in foreign currencies. The available data should provide lower-bound estimates, and they show high and persistent dollarization in some Latin American countries, while cross-border deposits increased significantly in the European Community during the 1980s, rising to 8% of broad money stock. Giovannini and Turtelboom conclude by discussing policy problems that arise from currency substitution and the ensuing instability of monetary aggregates.

Currency Substitution
Alberto Giovannini and Bart Turtelboom

Discussion Paper No. 759, April 1993 (IM)