SUBSTITUTION AMONG CURRENCIES: A PREFERRED HABITAT HYPOTHESIS

Abstract

This paper embeds the theory of currency substitution in the theory of the transactions demand for money. It agrues that the domestic currency, as the most convenient and preferred domestic medium of payments, is the preferred habitat for transactions balances. With foreign currencies acting only as liquid stores of value, the degree of currency substitution is further reduced by the presence of short-time bonds under a yield dominance hypothesis. The empirical evidence on Canadian money demand functions supports our analytical findings: the degree of substitution between the Canadian and U.S. currencies for Canadian residents is virtually non-existent. [430]

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