Currency substitution, political risk, and real exchange rate dynamics: A directional derivative essay

Integration and differentiation characterize international (business) relations. The first helps determine economic aims; the second, political realities. International monetary interdependence is a clear manifestation of the world system in which, economic agents from developing nations may be induced to hold a hard currency like the dollar. This choice is denominated a dollarization phenomenon since it is actually a market-enforced monetary reform triggered in the demand-side of the economy rather than a government-proposed monetary reform initiated in the supply-side.; Answers to issues such as these are not intuitively clear, particularly for Colombia. The inquiry raises the question of to what extent has an exchange rate misalignment been caused by a currency substitution phenomenon under conditions of political risk and its aftermath materialized in a deterioration of the international business operations of Colombia.; A directional derivative (DD) approach is proposed to answer this question. The DD approach yielded a recursive multilevel model in three stages, fundamental, transitional and transformational, to represent current policy response, the black market, and the state of dollarization, respectively.; A CES production function to generate real money services is considered subject to an 'asset constraint'. A standard monetary model for long-term equilibrium, and an asset model are considered as well to yield a 'synthesis' model for exchange rate determination.; Quarterly data were obtained to test the recursive multilevel model for the period 1979III-1990II. Empirical results support such a view. Causality and structural stability tests were performed. It may be concluded that the black market, though a follower of the official market, has not imposed a higher pressure on the official exchange rate because it has found other routes to influence the Colombian economy as a whole. Currency substitution has been one of the chosen vehicles to incorporate gradually an unofficial economy into the formal economy. Moreover, a 'synthesis' model shows exchange rates may overshoot when a policy reaction function includes currency substitution under conditions of political risk.