Extending the evidence on elasticity of currency substitution: The case of Mexico, 1989--1999

This study examines evidence on elasticity of currency substitution in Mexico during the 1990s to assess the expected effect of a price stabilization policy using a permanent reduction in the rate of money growth given the presence of currency substitution in a small open economy. The primary issue is whether such a policy leads to a temporary appreciation or depreciation of the real exchange rate. The secondary issues concern the linkage between real exchange rate dynamics and the effectiveness of monetary policy, the need for adjustments in fiscal policy, the impact on the inflation tax base, the optimality of the exchange rate regime, the stability of a nation's banking system, and the persistence of currency substitution, known as hysteresis, even with decreases in the inflation rate. The first issue depends on whether the elasticity of currency substitution is larger or smaller than the elasticity of substitution between consumption and liquidity services.; The main empirical objective of this dissertation is to ascertain the relative magnitude of the relevant elasticities of substitution, using a model of preferences within a class of non-expected utility models. Within this framework, it is possible to estimate elasticities of substitution between domestic and foreign currencies and between consumption and liquidity services, along with parameters of risk aversion and intertemporal substitution.; In general, the empirical results show that elasticity of currency substitution is greater than intratemporal elasticity of substitution between consumption and liquidity services. This supports the condition that a one-time permanent decrease in the rate of expansion in the money supply leads to a temporary appreciation of the real exchange rate and to a trade deficit. As a result, the policy maker would be likely to call off the price stabilization program, thus enhancing the need for adjustment in fiscal policy, since the inflation tax base is not a viable source of deficit finance. With the failed stabilization, the policy maker faces an increased likelihood of capital outflows induced by expectations about potential future devaluations, weakening the domestic financial system. In addition, the empirical evidence suggests that Mexican residents derive a high degree of liquidity services from holding foreign demand deposits, suggesting that reliance on currency substitution remained important in Mexico through the 1990s.