Effectiveness of the monetary and fiscal policies under the currency substitution

Ill ABSTRACT In fact, currency substitution concept could have been used with different meanings in different studies, the most general meaning refers to useage as mean of exchange of a foreign currency instead of domestic currency. On the one hand, while currency substitution reflects the macroeconomic instabilities and the existence of distortions in financial markets, on the other hand, it could be a reason of the this instabilities and its distortions. Currency substitution usually occurs in the high inflation countries with underdeveloped financial markets. As in this countries inflation rates increase, there is usually a shift away from the domestic currency toward a foreign currency. The subject of the study is to discuss the effectiveness of monetary and fiscal policies under the currency substitution. Currency substitution leads to a downward shift in the demand for domestic money, narrowing the inflation tax base and trasferring seigniorage to abroad. Thus, under the currency substitution, domestic government loses part of its domestic inflation tax base and seigniorage revenues. In other words, as public shift from domestic currency to a foreign currency, the domestic inflation tax base is erodes. Under the currency substitution the central bank can be unable to stop financial crisis by injecting liquidity or can not serve as the "lender of last resort". In addition, the central bank's ability to conduct monetary policy may be substantially undermined, since the foreign currency component of the total money supply cannot be direct controlled by monetary authority. Particulary, foreign exchanges circulating within the economy is out of the direct control of the central bank. Consequently, under the currency substitution, the ability of policy maker to conduct monetary and fiscal policies effectively is weak. In this mean, the effectiveness of monetary and fiscal policies reduces.