2003 Volume 12 Issue 2 Pages 81-96
Currency substitution, the holding by residents of foreign currency as a mean of payments, is a common feature of high inflation economies such as Latin American countries. In condition of high inflation, the public wants to protect from high costs of using and holding domestic currency, and looks for alternatives, for example, U.S. dollar.
While most Latin American countries have succeeded in stabilizing macroeconomies in recent years, the degree of currency substitution is still continue to be high. These phenomena are known as “ratchet effects” in currency substitution.
The purpose of this paper is to analyze whether in six Latin American countries; Argentina, Bolivia, Mexico, Paraguay, Peru, and Uruguay, the degree of currency substitution has decreased in the second half of 1990's when macroeconomies are stabilized.
We derive estimated equation from currency substitution-type of money-in-the-utility-function model that has microeconomic-foundation to avoid ad hoc specification of money demand function. Moreover, we use ARDL (autoregressive distributed lag) approach for estimation to analyze not only short-term effects but also long-term effects.
Our estimation results show that the degree of currency substitution in all Latin American countries has not been affected by a reduction of interest rates differentials in our sample period. This finding seems to imply that in Latin American countries there exist “ratchet effects” in currency substitution. Therefore, we add a new variable that reflects ratchet effects to the estimated equation and confirm that there certainly exist ratchet effects in currency substitution in Argentina, Bolivia, Mexico and Uruguay.