Stocks,flows, and some exchange rate dynamics for the currency substitution model

The paper argues that the treatment of stocks and flows in portfolio balance models of exchange rate determination is inadequate, and that this hampers the analysis of exchange rate dynamics. A proposed resolution is reworked into the currency substitution model. In addition to providing explicit solutions for the spot rate of exchange depreciation under different expectational hypotheses, an attempt is made to clarify the dynamic properties of the model. Inter alia, it is shown how exchange rate overshooting is possible without having to assume market frictions; how a deteriorating current account deficit can coexist with an appreciating exchange rate; and, more generally, how portfolio induced jumps in the exchange rate are linked to balance of payments flow influences on the evolution of the exchange rate.