Currency Substitution and the Moneyness of Monetary Assets

Abstract

The previous literature on dollarization processes has two basic problems. First is the poor empirical methods of measurement, and second is the lack of a clear definition of the phenomenon under study. Several methodological problems have not been successfully addressed. Foreign currency holdings cannot be measured directly, and the dollarization ratios are very imprecise as they do not take into account institutional considerations. We present a simple model in which monetary assets are held for two motives: transactions and a store of wealth. Based on the Divisia literature, the model emphasizes the difference in liquidity properties in different monetary assets. In a dollarized economy, this notion is particularly important as we can distinguish two separate phenomena: currency substitution and asset substitution. The first one is measured as the share of total liquidity obtained from dollar- denominated assets. The second one is not related to transactions and, therefore, is just the share of total financial assets that is held in dollar-denominated assets. The model predicts a close relationship between asset substitution and the interest rate differential and between currency substitution and the inflation rate differential. Using the Peruvian dollarization experience (1978-1996), we found significant evidence supporting these hypotheses. Furthermore, we reject the presence of hysteresis as the corrected currency substitution ratios are cointegrated with the inflation differential rate.