Exchange Rate Economics: Theories and Evidence

190 Currency substitution and portfolio balance models
Initial trade
deficit
C T
C T 9
Y T ,C T
Y T
A
Final
equilibrium
surplus
B
Y T
C T
B9
B
C T 9
F
S 0
X
F9
Z
F
S 1 Y
F9
B
B9
0 i 1 i 0
i
Figure 7.12 A shift in asset preferences.
At the initial equilibrium,the increased demand for domestic bonds can only be
satisfied by a reduction in the rate of interest,giving the leftward shift from BB to
BB ′ . Equally the attempt to move out of foreign bonds can,in the impact period,
only be satisfied by a leftward shift of the FF schedule. Thus the impact effect of a
change in asset preferences from foreign to domestic bonds results in a reduction
in the interest rate and the exchange rate: from i 0 to i 1 and from S 0 to S 1 .
Moving from the impact period to the short-run adjustment period,we find that
private sector wealth has increased due to the fall in the price of the traded good
and thus w must be greater than ¯w and agents dissaving. This is illustrated in the
left hand side of Figure 7.12 where the initial current account deficit is equal to
AB. Over time this deficit will result in a loss of the foreign asset and a reduction
in wealth which pushes C T C T to the right and the exchange rate upwards. If the
domestic economy lost foreign assets during the adjustment period it would end
up with a final equilibrium at a point such as Z.
7.5 Empirical evidence on currencysubstitution
As was demonstrated earlier in this chapter,the concept of CS has an important
bearing on the insulation properties of a floating exchange rate system. Thus it
seems worthwhile to ascertain if the hypothesis is empirically verifiable. Before
considering the empirical studies which attempt to directly test for CS it is worth
noting that Bilson (1979a) has interpreted the coefficient on the relative interest
rate term in monetary approach equations as a measure of the substitutability
of currencies. But as Bilson recognizes,it is impossible to discern whether this
reflects substitution between currencies,between the home currency and bonds,
or between the home currency and goods. As we shall see,this problem plagues
nearly all the empirical studies of CS.