Currency substitution

The concept of “currency substitution” in economic theory was introduced by Guillermo Calvo and Carlos Rodriguez during their work at the University of Buenos Aires (Argentina) in 1977 ^[1] . The expression was used by them in the analysis of the real exchange rate in the conditions of foreign exchange substitution. The main conclusion reached by the first researchers was that, in the presence of currency substitution, an increase in money supply leads to a depreciation of the national currency. The term has been actively used in economic literature since the 1970s, when the processes of currency deregulation and liberalization of financial markets began in developing economies.

Two main concepts of currency substitution are distinguished. One of them was developed by Guillermo Calvo and Carlos Veg ( Johns Hopkins University ). In their version, foreign exchange substitution is the use of foreign currency in the domestic market as a medium of circulation ^[2] . If economic agents use foreign currency not only as a medium of circulation, but also as a measure of value and a means of saving, we are talking about unofficial dollarization.

An alternative concept is proposed by Ronald McKinnon of Stanford University ^[3] . He distinguishes between direct and indirect currency substitution. The definition of direct currency substitution is the same as that of Guillermo Calvo and Carlos Vega. Direct foreign exchange substitution reflects competition between currencies as a medium of exchange. Indirect currency substitution means switching economic agents between non-monetary financial assets of different countries. Thus, Ronald McKinnon's indirect foreign exchange substitution means international substitution of financial assets ( asset substitution ) in the broad sense. In other words, it describes international capital mobility, which allows economic agents to form a portfolio of financial assets of different foreign jurisdictions.

Between a broad and narrow interpretation of currency substitution, there is a wide range of intermediate definitions. All of them consider currency substitution as a process of crowding out national money with foreign money as a tool that performs some or all of the monetary functions. For example, in one of the works, Carlos Veg together with Ratna Sahai defined currency substitution as the use of foreign currency by economic agents as a medium of exchange and a measure of value, while substitution of assets described the use of foreign currency as a means of savings ^[4] .

Alexei Kireev, author of the popular textbook International Economics and an IMF staff member, believes that “any parallel circulation of several currencies is called either dollarization or currency substitution, using these concepts as synonyms” ^[5] .

The theoretical models in which currency substitution is considered are represented by two groups: analysis on an individual basis (one economy where several currencies can be traded) and analysis on a group basis (two or more economies that allow mutual exchange of currencies). In general, models for the analysis of currency substitution are divided into several groups ^[6] :

• cash-in-advance models , which are based on the assumption that all goods and services in the economy can be purchased only for cash and payment is made immediately at the time of the transaction;
• portfolio-balance models , where money is considered along with other assets included in the portfolio of an economic agent;
• money-in-the-utility-function models , in which households benefit from money, including real cash balances, and this is reflected as an argument to the utility function,
• models of transaction costs, where the use of money can reduce (increase) the real costs of transactions;
• ad hoc models for case studies.

Modeling the demand for domestic money shows that foreign exchange substitution is a function of several economic variables: the opportunity cost of storing different currencies, the inflation differential between the domestic and foreign markets, the differential of nominal and real interest rates between the domestic and foreign economies, and the expected and actual rate of depreciation or devaluation national currency.

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• Globalization and national financial systems. Ed. Hanson, J. A., Honohan, P., Magnoni, J. [trans. from English Vasiliev V.S.]. - Moscow: The World, 2005.
• Zolotarchuk V.V. Macroeconomics: a textbook for students of higher educational institutions studying in economic and non-economic specialties. - Moscow: INFRA-M, 2011.
• Shakhovskaya L.S. Pricing. - Moscow: Knorus, 2016.