Studies on currency substitution: Empirical evidence in Latin America

This dissertation examines the hysteresis phenomenon in currency substitution and develops two approaches for their empirical estimation in Latin American countries. The first approach is based on a transactions cost model where the decision of a representative agent in the holdings of different currencies depends on his expectations of the inflation rate and the change of the official and the black market exchange rates. If the expectations of inflation and change in the exchange rate do not decrease to a level below the "inaction band" created by the costs of using foreign currency in transactions, the persistence in currency substitution will continue.; The second approach uses a rational expectations model for the inflation rate that includes the inferences of agents about the credibility of the economic program implemented by the policy authority. Hysteresis in currency substitution is explained by the lack of credibility of the economic policy encouraging the economic agents to allocate their monetary holdings in foreign currency. Even if inflation rates decrease and exchange rates become more stable, the lack of policy credibility may cause economic agents to continue holding their assets in foreign currency. They keep their deposits in foreign currency because they expect that the policy authority will abandon its economic program.; The main contribution of these studies on currency substitution is the introduction of new methods to analyze the presence of hysteresis in currency substitution. An important result is the determination of a threshold level for the currency substitution ratio after which the original causal variables do not have any effect on the changes of the ratio of currency substitution. According to the estimation results, the hysteresis phenomenon occurs when the currency substitution ratio is 65% in Bolivia, 60% in Peru and 70% in Uruguay.; Another relevant contribution is the econometric estimation of policy credibility based on the inferences of the economic agents using information about the government expenditures and inflation rate. This study shows that the current presence of hysteresis in currency substitution can be explained by the lack of credibility of the stabilization program implemented in Peru in 1990.