The Currency Substitution Hypothesis and Relative Money Demand in Mexico and Canada

Abstract

The author estimates demand for dollars relative to domestic currency in Mexico and Canada using (1) a multivariate model with a relative money demand equation, and (2) single- equation models, including an error-correction representation. He also analyzes the models' encompassing properties. The anomalous correlation between the Mexican dollarization ratio and expected peso depreciation implies that "convertibility risk" was associated with holding Mexidollars. Under this interpretation, higher expected depreciation coincides with a drop in relative demand for dollars because there is the possibility that the government will forcibly convert Mexdollars when these central bank liabilities rise and foreign reserves run low. Several testable alternative explanations are rejected. Copyright 1992 by Ohio State University Press.

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