Currency substitution as an automatic stabilizer

Abstract

Abstract In the presence of frictions, the existing literature shows that currency substitution is detrimental for domestic aggregate stability. This paper singles out the role of currency substitution and shows that diversified currency holdings operate as an automatic stabilizer that mitigates belief-driven cyclical fluctuations in Farmer’s (1997) indeterminate monetary economy. When the foreign inflation rate is lower than the domestic inflation rate, the model’s steady state always displays saddle-path stability. Hence, equilibrium indeterminacy originally present in the domestic country is entirely removed in the presence of diversified currency holdings. When the foreign inflation rate is higher than the domestic inflation rate, then depending on the degrees of currency substitution and relative risk aversion, indeterminacy is either impossible or the requisite level of the foreign inflation rate for indeterminacy is too high to square with data. The stabilizing effect of diversified currency holdings on domestic aggregate stability is robust to whether domestic and foreign currencies display as Edgeworth substitutes or complements, or are additively separable in the household’s preferences.