A Dynamic Simulation Analysis of Currency Substitution in an Optimizing Framework with Transactions Costs

Abstract

This paper investigates the dynamic paths of inflation and real balances in a general equilibrium intertemporal optimization model, with transactions costs and currency substitution, when budget deficits are financed by money creation.

The results show that inflationary paths show more 'jumps' or explosions under the assumptions of lower transactions costs or an increasing degree of currency substitution. Even small changes in the degrees of currency substitution with positive transactions costs sharply change the paths of inflation and real balances. Similarly, small changes in transactions costs for foreign currency, even without prior currency substitution, have marked effects on the paths of inflation and real balances.

The results obtained from the simulated data are consistent with inflation processes in recent Latin American experience, where currency substitution may have taken place. Estimates of the simulated data for even a small degree of currency substitution generate generalized autoregressive conditionally heteroskedastic (GARCH) estimates of the inflation process, which are consistent with estimates for Argentina, Bolivia, México, and Perú. In these countries currency substitution may have gone hand-in-hand with inflationary instability through money-financed fiscal deficits.

Our results suggest that fiscal deficits financed by monetary expansion should be avoided under conditions of increasing financial openness, which provide greater opportunities for financial adaptation through currency substitution or lower transactions costs on foreign currency accumulation.