DP535 | Currency Substitution and the Fluctuations of Foreign-Exchange Reserves with Credibly Fixed Exchange Rates

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01/05/1991

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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.