Exchange Rate Determination and Currency Substitution: Micro Analysis and Macro Implications

Vries, C.G. de (1983). Exchange Rate Determination and Currency Substitution: Micro Analysis and Macro Implications. IIASA Collaborative Paper. IIASA, Laxenburg, Austria: CP-83-061

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Abstract

The purposes of this essay are threefold: first, to provide a microtheoretic framework that incorporates the transaction motive for holding money in a multicurrency world; second, to show how the recent "currency substitution theory" can be embedded in the micro choice model we develop; third, to derive some comparative static results from a macro model that allows agents to hold different currencies.

Recently, Cuddington noted in a paper discussing the issue of currency substitution that we still lack an explicit microtheoretic framework clarifying the transaction roles of different currencies in a multicurrency world. Tobin also seems to call for an analysis of the service yields of different currencies. The next section discusses what properties a transaction technology describing the transaction roles of currencies should satisfy. Section 3.1 then formalizes the individual choice problem that determines the demand for the various currencies.

The second part of section 3 describes how the currency substitution literature is related to our model. Several results on currency substitution are shown to be nested hypotheses of our general model.

A short-run general equilibrium model for two open economies is developed in the fourth section in order to derive some implications in the presence of currency substitution. The way in which expectations are introduced into the model can be described as a form of bounded rationality. The exchange rate in the model has the feature that it is an element of the price to holders of one currency of every asset and commodity denominated in the other currency.

In the last section we investigate the issue of currency substitution on a macro level. By comparing comparative static results for economies with and without currency substitution present, we are able to analyze the qualitative and quantitative aspects of currency substitution.

Mathematics is relegated to the appendices, together with a list of symbols.

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