Currency substitution and exchange rate dynamics: A note

Abstract

In an interesting paper Girton and Roper [ 1981 ] examine the effects of currency substitution on exchange rate variability. They find that currency substitution increases exchange rate volatility and that the exchange rate is indeterminate when currency substitution approaches infinity. It is only by endogenizing the behavior of money issuers in the second part of Girton and Roper' s paper and by assuming that central banks behave as profit maximizers that they are able to show that currency substitution enhances exchange rate stability. The main reason for the latter result is that central banks are assumed to respond to demand shifts for their currencies in an attempt to maximize profits. The first part of the Girton and Roper paper, dealing with exogenous money supplies, relies heavily on two assumptions. Namely, the assumption that purchasing power parity (PPP) holds at every instant in time and the assumption of perfectly flexible commodity prices. Thus changes in relative money supplies affect relative national price levels immediately, and given PPP, cause proportional changes in the exchange rate. By contrast, expected depreciation of one of the two currencies decreases the differential between its anticipated real return and that of the other currency. This in turn causes a decrease in its demand and a symmetrical increase in the demand for the other currency. Moreover, the demand for the first currency further decreases as its anticipated real return falls in relation to the non-monetary asset. In the latter case, the degree of change in the relative national price levels and hence exchange rate change depends on the degree of currency substitution. If the two currencies are close substitutes, the resulting shifts in their de-