BOFIT Discussion Papers, Institute for Economies in Transition, Bank of Finland
No 14/2010:
Currency substitution in the economies of Central Asia: How much does it cost?
Asel Isakova ()
Abstract: Underdeveloped financial markets and periods of high
inflation have stimulated dollarization and currency substitution in the
economies of Central Asia. Some authors argue that the latter can pose
serious obstacles for the effective conduct of monetary policy and can
affect households’ welfare.This study uses a model with
money-in-the-utility function to estimate the elasticity of substitution
between domestic and foreign currencies in three economies of Central Asia
- Kazakhstan, the Kyrgyz Republic and Tajikistan. Utility derived from
holding money balances is represented by a CES function with money holdings
denominated in two currencies. The residents are assumed to diversify their
monetary holdings due to instability of the domestic currency. The steady
state analysis reveals that though currency substitution decreases
governments’ seigniorage revenue, holding foreign money can be welfare
generating if domestic currency depreciates vis-à-vis the currencies in
which households’ foreign balances holdings are denominated.
De-dollarization can only be achieved through further macroeconomic
stabilization that will bring price and exchange rate stability. Financial
sector development will also decrease currency substitution through the
provision of reliable financial instruments and the gaining of public
confidence.
Keywords: currency substitution; dollarization; monetary policy; seigniorage; welfare; transition; (follow links to similar papers)
JEL-Codes: E41; E58; P20; (follow links to similar papers)
53 pages, July 26, 2010
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