“Confidence in Domestic Money and Currency Substitution” by Yong WANG
Chinese University of Hong Kong
This paper studies the dynamics of currency substitution in an economy in which the lack of confidence in domestic money leads to demand for foreign money as an alternate store-of-value. We focus on the role of beliefs in determining the relative demands for domestic and foreign money. We study both the cases where the level of confidence in domestic money is constant and where it evolves endogenously. We show that while the unique dual-money steady state under the constant beliefs is unstable, the economy under endogenous beliefs can exhibit multiple, stable dual-money steady states. Therefore, currency substitution is robust and persistent – it will not be eliminated by reductions in domestic inflation. Furthermore, the multiple steady states, when exist, can be Pareto ranked by the degree of currency substitution.