Working Paper: CEPR ID: DP535
Authors: Alberto Giovannini
Abstract: A fixed-exchange-rate system is characterized by two pillars: monetary policy coordination and foreign exchange reserves. This paper concentrates on the fluctuation of foreign exchange reserves by taking monetary policy coordination as given: the sustainability of the fixed exchange rate regime is insured via a cointegration restriction on the path of money supplies. The paper considers three types of cash-in-advance models of money demand. The first two types are more traditional models where the cash-in-advance constraint is applied on the goods produced in the two countries. The third type is a model where cash is required in transactions with the government. The main finding is that when the exchange rate is credibly fixed, currencies are perfectly substitutable as stores of value although they might not be perfectly substitutable as transactions media. While the total demand for money is always determined, the composition of foreign exchange reserves might be indeterminate if currencies are held for store-of-value purposes only.
Keywords: currency substitution; demand for foreign exchange reserves; money demand; fixed exchange rates
JEL Codes: 431; 432
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| substitutability of currencies as stores of value (F31) | fluctuation of foreign exchange reserves (F31) |
| substitutability of currencies as transaction media (E41) | variability in foreign exchange reserves (F31) |
| public expectations regarding future currency values (F31) | demand for foreign exchange reserves (F31) |
| total demand for money (E41) | composition of foreign exchange reserves (F31) |