Exchange Rate Economics: Theories and Evidence

168 Currency substitution and portfolio balance models
We now examine the implications of CS for the determination of the exchange
rate in a monetary approach framework. The models we consider share the common
feature that domestic residents can hold their wealth,W,in a portfolio of
either domestic money, M ,or foreign money,M ∗ :
W = M + M ∗ . (7.4)
The proportions of the two currencies held depends on the expected change in
the exchange rate,and changes in the expected rate lead to attempts by portfolio
holders to substitute between currencies. The variant of the flex-price monetary
model considered in Section 7.2.1 highlights the importance of risk/returns factors
(and their determinants) as a basis for agents’ decisions to substitute between
currencies. In Section 7.2.2 two currency substitution models are discussed which
tackle a deficiency that has characterised the exchange rate models considered
hitherto,namely their lack of stock–flow interactions. A general equilibrium CS
model is sketched in 7.2.3.
7.2.1 Currency substitution (CS) and the flex-price
monetary approach
In the monetary models of the exchange rate considered so far,monetary services
are only provided by the domestic currency. However,and as we have argued,
this is probably an unrealistic assumption; various international companies have
an incentive to hold a variety of currencies and therefore monetary services may
be provided by other currencies. This may be illustrated by rewriting the kind of
money demand function used in other chapters as:
M D /P = (Y , i),(7.5)
where is the proportion of monetary services provided by domestic money.
Clearly if = 0 we are in the sticky/flex price monetary approach world. In a
world of CS is assumed to lie between zero and unity,and hence 1 − gives
the proportion of monetary services provided by foreign money.
Following King et al. (1977),the share of foreign currency,for a given institutional
structure,depends upon exchange rate expectations and the uncertainty,Ɣ,with
which these expectations are held:
= f (ṡ e , Ɣ), f 1 < 0, f 2 < 0,(7.6)
where f 1 and f 2 are partial derivatives (f 1 = δ/δṡ e ). Thus expectations of an
exchange rate depreciation tend to decrease holdings of domestic money as does
increased uncertainty. Exchange rate expectations are argued to depend on the
expected future monetary growth for a given structure of foreign monetary policy
ṡ e =ṁ e and uncertainty is assumed to be a function of the variability,or variance,
of domestic money supply: increased variance raises the level of exchange rate