| Abstract: | This paper examines the dynamic of currency substitution (CS) in Egypt and South Africa. The study also assesses the causal relationships of this phenomenon. There are three main CS‐related differences between the two countries. These are (1) the orientation of economic policy, (2) the degree and level of CS, and (3) the trend of CS. During the study period 1991‐2001, Egypt used the exchange rate as an anchor to its economic programme. While in the case of South Africa, the authorities directly targeted inflation. During this period, CS in Egypt started at a substantial level and experienced a steady decline. Conversely, CS in South Africa started at an insignificant level, but observed an uninterrupted increase. The results suggest that the elasticity of CS, with respect to exchange rate, of South Africa is 2.3 times that of Egypt, and that the speed of adjustment in South Africa is 5 times faster than in Egypt. Granger‐causality tests indicate a unidirectional relationship from the exchange rate to CS, in both Egypt and South Africa. The test for the interest rate differential and CS indicate that causality runs from the former to the latter in South Africa, but it runs in the opposite direction in Egypt. The study suggests that despite the cost of the exchange rate anchoring policy, it is more suitable to a high CS environment. Inflation targeting policy can be effective in achieving its objective as long as the CS is insignificant. |
