A microfounded approach to currency substitution and government policy

Abstract

This paper develops a search-theoretic, two-country, dual-currency model featuring endogenous currency substitution with costly authentication of foreign currency. Benevolent governments, unable to commit to future policies, determine fiscal and monetary policy weighing distortion-smoothing and time-consistency. Decisions of the fiscal authority are accommodated by the monetary authority, where public expenditures, public debt, labor taxation, and inflation are determined using the notion of a Markov-perfect equilibrium. Inflation differentials arise endogenously from cross-country heterogeneities in the citizens' valuation of public goods, rendering international differences in fiscal imbalances the root cause for currency substitution. A steady-state analysis characterizes long-run allocations and identifies the domestic and foreign governments' best responses to changes in local payment patterns. Historical data supports the theoretical findings and provides empirical evidence for the positive relationship between currency-substitution ratios, inflation, and public debt. An extension studying de jure dollarization shows that time-consistency concerns disappear once currency substitution is imposed exogenously, reducing the government's objective to distortion-smoothing exclusively.