Currency Substitution: a Test of Its Importance

Currency Substitution: A Test of Its Importance Dallas S. Batten and R. W. Hafer habitual defense of flexible exchange place is that they insulate the national economy and money supply from international monetary disturbances. This view has been challenged by a number of critics who question the assumption behind the monetary independency argument that domestic and foreign currencies are not considered substitutes in entreat by domestic residents.2 A rational carrier of money balances, these critics argue, would wait onk to diversify his portfolio of. currencies for the same reasons that investors typically induce diversified portfolios of interest-earning assets. If currency switch exists, domestic money demand should be sensitive to changes in both domestic and foreign influences. Consequently, even with flexible exchange rates, the existence of currency surrogate exposes the domestic economy to monetary shocks from both home and abroad. The exercise of this article is to assess empirically the importance of currency substitution in five major industrial countries by examining the signification of changes in the hazard costs of holding foreigncurrency-denominated money balances on the demand for domestic money.

If currency substitution exists, changes in the opportunity costs of holding foreign money balances should generate a reallocation of money holdings and, consequently, influence domestic money demand. The licence presented here, however, indicates that the impact of changes in Dallas S. Batten and A. W. Hafer are senioreconomists atthe Federal Reserve savings bank of St. Louis. Sarah A. Driver provided research assistance. The case tor flexible exchange rates is made forcefully in Friedman (1953). In this analysis, we ignore the mishap that rnonetarydisturbances in a flexible exchange rate dry land may have real consequences as goods prices change to a greater extent slowly than do exchange rates. For a discussion of this, see Dornbusch (1976). 2 For a discussion of... If you want to get a full essay, order it on our website: Ordercustompaper.com

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