Foreign exchange market liberalization and the demand for money in the presence of currency substitution

Two theoretical models are presented to illustrate that, in the presence of currency substitution, liberalization of the foreign exchange market has two important and unrecognized effects on the demand for money. First, the demand for money decreases following liberalization--a rightward shift of the LM curve. Second, the demand for money becomes more interest rate inelastic--a steepening of the LM curve. These two phenomenon have significant policy implications.; In the first model the demand for money is separated into the demand for money as a medium of exchange and the demand for money as a store of value. Upon liberalization, the demand for money decreases as agents switch to foreign currency, which is now an alternate financial asset and assumes some of the store of value function. The demand for money as a medium of exchange is less sensitive to the interest rate than as a store of value. As domestic money increasingly serves only as a medium of exchange it becomes less sensitive to the interest rate.; In the second model, a neoclassical optimization approach is adopted where both domestic money balances and foreign money balances are included in the utility function. It is shown that upon liberalization, modeled as reduced transaction costs or increased utility associated with holding foreign currency, the demand for domestic money decreases and becomes less sensitive to the interest rate.; Using Zambia as a case study, empirical tests indicate that these two phenomenon did indeed arise following liberalization. The tests undertaken include a dummy variable version of the Chow test set in a VAR framework, as well as demand for money specifications using contemporaneous and lagged values of the interest rate, income, inflation and exchange rate. Kalman Filtering was used to identify any endogenous regime shift rather than imposing liberalization as the regime shift. The theoretical findings are confirmed in all cases. That is, the demand for money declined and became less interest rate sensitive following liberalization.