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The phenomenon of currency substitution in response to differentials in rates of return (inflation rates) has been widely analyzed in the literature. A common feature of the early studies (see, for instance, Kouri (1976), Calvo and Rodriguez (1977), and Girton and Roper (1981)) is that they were based on an asset view of monetary holdings. According to this approach, demand for the different monies is a stable function of conventional variables such as income, wealth, and their respective opportunity costs, measured by inflation rate differentials or, alternatively, by the nominal interest rate differential, corrected by the change in the relative price between currencies. Basically, these models placed the phenomenon of currency substitution on a par with that of optimal portfolio composition in a world with capital mobility. Currency holdings and flows were thus treated identically as foreign asset holdings and as capital flows in general.
More recent studies (see, for instance, Liviatan (1981), Calvo (1985), Boyer and Kingston (1987), Guidotti (1989), Vegh (1989), and Sturzenegger (1990)) have emphasized the role of currency substitution at the level of the transactions demand for money. In these studies, therefore, the demand for domestic and foreign money is motivated more explicitly by a transactions motive, often abstracting specifically from the store of value motive and from portfolio composition considerations.(1) However, a crucial assumption common to all of these studies is that foreign and domestic money are imperfect substitutes. This assumption implies that the derived money demand functions have the same qualitative properties as those obtained from portfolio considerations.
Among Latin American countries with high inflation, at least since the 1970s, something along the lines of currency substitution has been going on under the name of "dollarization." In several of these countries-Argentina, Bolivia, Peru, and Uruguay among the most visible--the U.S. dollar has gradually but persistently been replacing national currencies in the performance of all types of monetary services. Not only have dollars replaced "pesos" in the local portfolios but, more importantly, dollars are often being used for settling current transactions and as a unit of account.
The standard approach to currency substitution views dollarization as a phenomenon that is easily reversible once the relative rates of return on the alternative monies are changed. This follows directly from the fact...