Exchange Rate Economics: Theories and Evidence

Currency substitution and portfolio balance models 167
exchange controls in the post-Bretton Woods period by most of the participating
members of the generalized float.
The kind of currency substitution referred to above,where agents hold a basket
of home and foreign currencies and switch between these currencies in response to
expected currency movements,is usually referred to as direct currency substitution.
In practice it is likely that only a small proportion of a country’s non-interestbearing
money stock would be held by non-nationals. 4 Before considering models
which seek to model this kind of direct CS,it is worth noting that an indirect form
of CS,which is closely related to the more familiar concept of capital mobility,may
quantitatively be more important than direct capital mobility. Thus,expectations
of an exchange rate change will induce substitution between non-money assets,
such as bonds,and this will result in a form of currency substitution. This indirect
form of CS may be illustrated with the following example from McKinnon (1982).
For example,assume that the world consists of two countries,home and foreign,
and uncovered interest parity is maintained between their non-money assets.
i − i ∗ =ṡ e ,(7.1)
The two countries are assumed to have issued bonds,V,and the interest rates in
each country are determined as:
i = i w + (1 − a)ṡ e ,(7.2)
i ∗ = i w − aṡ e ,(7.3)
where i w is the nominal world yield on bonds and is given by:
i w = ai + (1 − a)i ∗ ,
where a is the financial weight of the home country (in this case the US) in the world
financial markets as measured by the ratio of dollar to total bonds outstanding –
a = V/V ∗ .Ifa is assumed to be,say,0.5 and s is the home currency price of
foreign currency then an expected depreciation of the home currency of 10%
will result in an increase in the home rate relative to the world rate of 5% and a
reduction in the foreign rate of 5%. If expectations are commonly held,significant
capital flows need not take place since the rates will adjust immediately to eliminate
arbitrage incentives. However,the higher (lower) interest rate in the home (foreign)
country results in agents holding less home currency and more foreign currency.
To put this differently,the capital outflow from the home to foreign country is an
exact reflection of the reduced demand for the cash of the home country and the
increased demand for the cash of the foreign country. McKinnon (1982) argues that
quantitatively this indirect form of currency substitution may be more important
than the direct form of currency substitution: ‘Massive capital flows can easily be
induced even when the interest differential remains “correctly” aligned to reflect
accurately the change in expected exchange depreciation.’ 5 Although indirect CS
may be the more important form of CS,it would clearly be impossible to distinguish
it from ordinary capital mobility.