Substituting a Substitute Currency – The Case of Estonia

This study evaluates substitution of foreign currency balances in Estonia, a transition economy neighbouring countries participating in EMU. The focus is on substitution between dollar and euro balances in the three basic functions of money – unit of account, store of value and means of payment. While traditional models for currency substitution concentrate on substitution between a domestic currency and aggregate foreign currency balances, we look for substitution between the dollar and the euro or euro-related foreign currency balances. We find substitution between dollarization and euroization to be asymmetric in the short run, which suggests that inertia, irreversibility and ratchet effects favour the euro. No significant evidence of asymmetries in the long run was detected. In general, the traditional model for currency substitution explains the dynamics of the euro and dollar as substitute foreign currencies.

Introduction: Ahead of the euro’s launch, the new currency was expected to seriously challenge the US dollar’s preeminent role as the world’s leading monetary vehicle and substitute currency. Portes and Rey (1998), Hartman (1998) and McCauley (1997) all predicted that that the euro would serve as a sub-stitute for the dollar as an internationalized currency. Among Central and East European Countries (CEECs), especially those hoping to join the EU and participate in Economic and Monetary Union (EMU), substitution of euros for dollars seems quite likely.In effect, economies formerly re-garded as look destined to become .This study exam-ines the dynamics of this shift in substitute currencies. We do this by esti- mating the degree of substitution between euro and US dollar balances in Estonia, and then use Estonia as a representative transition CEEC.

Author: Kari Heimonen

Source: Institute for Economies in Transition, Bank of Finland

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