Confidence in Domestic Money and Currency Substitution

Abstract

This article studies currency substitution in a model where domestic money suffers from lack of confidence. When agents' confidence is exogenous and constant, there is a unique but unstable dual‐money steady state. However, when agents' confidence is updated endogenously, the dynamics of currency substitution are driven by agents' evolving beliefs, and the economy always converges to an equilibrium where both monies circulate. Therefore, the economy under endogenous beliefs exhibits both persistence in currency substitution and tenacity of domestic money. Furthermore, in general, there are multiple steady states, which can be Pareto ranked by the degree of currency substitution.