Currency substitution and dollarization in Lebanon: Elasticity of substitution, capital mobility and hysteresis

Fifteen years of civil war and the economic crisis in 1992 left remarkable scars on the Lebanese economy. The dramatic devaluation of the Lebanese Pound (LBP) and high inflation rate imposed a real threat for the wealth of individuals and firms. They sought refuge in the US dollar (USD) to replace the LBP as a mean of exchange, store of value, and even as a unit of account.;In this dissertation, we analyze three main topics. First, we empirically investigate the degree of currency substitution using the monetary service model of De Vries (1988) for three periods: cumulative (1977-2006), civil war (1977-1989), and post-war (1990-2006). Our empirical findings reveal a high degree of currency substitution in the cumulative and the civil war periods, and inelastic currency substitution in the post-war period, driven mainly by successful post-war stabilization policies.;Second, we use Cuddington's model to investigate the real purpose of using USD, whether it was to facilitate business transactions (currency substitution) or to protect wealth and portfolio diversification (capital mobility) in the three periods: cumulative, civil war, and post-war. Our empirical analyses show that Lebanese economic agents used USD for transaction purposes, as well as for portfolio diversification, in the cumulative and civil war periods. Our models show statistically insignificant currency substitution and capital mobility in the post-war period, which shows a growing confidence in Lebanese future and in the Lebanese currency.;Finally, we also use Cuddington's model to investigate the persistent use of USD as a mean of exchange and a store of value in the cumulative, civil war, and post-war periods. Our analyses show strong indication of the persistent use of USD as a mean of exchange in the three periods. However, persistent use of USD is shown in the cumulative and civil war periods, but not in the post-war period. Hence, foreign money should be considered an integral factor in assessing monetary policies. It is interesting to see if that confidence will continue in the ongoing political crises after the assassination of former Prime Minister Hariri.