This paper attempts to synthesize two seemingly unrelated and thus independently examined behaviors, i.e. the pricing and the money holding behaviors, of the representative agent, and then rigorously analyze its consequences, currency substitution (CS, hereafter), to the optimal decisions within a so-called new open economy macroeconomic (NOEM) model (Lane, 2001; Mark, 2001; MacDonald, 2007; Walsh, 1998). The ultimate purpose to be elaborated is to explore "stabilizing" characteristics of CS.
Methods:
We think it is imperative to investigate Pricing-to-Market (PTM) and CS within a synthesized model for logical consistency. We construct a NOEM model with both PTM and CS, where a representative agent derives their expected liquidity services optimally from their lifetime allocation of assets between domestic and foreign money stocks, as a result of lifetime utility maximization (Duncan, 2003). Contrary to the conventional theoretical and empirical inferences of destabilizing characteristics of CS as reviewed in the survey section, we will show that CS has "stabilizing" effects within our NOEM model.
Results:
CS is shown to display its effects only when PTM firms exist. CS is stabilizing the exchange rate movements in the short-run by mitigating volatility magnified by PTM. Effects of expansionary monetary policy are weakened because of a consumption reducing effect of CS. We also found that CS works as an insulation device to protect from a beggar-thy-neighbor effect by PTM.