Inflationary Finance, Capital Controls, and Currency Substitution |
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Authors: | Ajay Tandon & Yong Wang |
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Institution: | Virginia Polytechnic Institute and State University, USA,;Chinese University of Hong Kong |
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Abstract: | This paper studies currency substitution in an environment where agents' inflation tax-evasive demand for foreign money is balanced by the concern for the possibility that the government may impose economy-wide capital controls under which foreign currency transactions are costly. Under the assumption of endogenous beliefs, the results show a persistent demand for foreign money despite efforts by the government to reduce inflation. In addition, the economy can exhibit multiple, Pareto-ranked steady states with different levels of currency substitution. The stability analysis suggests that the economy converges to the inferior steady state, on the "wrong side" of the Laffer curve. |
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