SFB 303 Discussion Paper No. B - 150

Author: von Hagen, Jürgen, and Manfred J.M. Neumann
Title: Currency Substitution and the Demand for Money. Further International Evidence
Abstract: In this paper, we present a formulation of the money demand function which separates currency substitution (CS) and bond substitution (BS). It is based on the familiar notion that money is a more liquid asset than bonds. Specifically, we assume that agents can adjust the currency composition of their portfolios at negligible transaction cost while transactions with bonds carry a fixed cost. Consequently, agents never plan to sell bonds prior to maturity. Our model implies that the choice between domestic and foreign money depends on expected rates of currency depreciation over a shorter time horizon than the choice between money and bonds. This gives rise to a sharper empirical distinction between the two types of asset substitution.
Another feature of this study is to estimate money demand functions under the assumption of rational expectations and to use an instrumental variables (IV) estimator that allows to relieve the awkward assumption, made in earlier studies, that interest rates and exchange rates are exogenous to the money demand equation (Cuddington, 1983). Furthermore, we use higher-frequency data and more recent data than previous studies. We estimate monthly money demand functions for France, Germany and the U.K. covering the period 1973 - 1987. CS and BS are modeled with respect to the US dollar. The data permit us to look at two possibly distinct time periods of the flexible exchange rates era, namely before and after the foundation of the European Monetary System.
We proceed as follows: Section II presents a model of money demand in an open economy with CS and BS. Section III reports the empirical analysis and results. The main findings and conclusions are summarized in Section IV.
Creation-Date: May 1990
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