Currency substitution and its macroeconomic impacts (The case of Turkey after 1980`s)

ABSTRACT The objective of this study is to examine currency substitution and its macroeconomic impacts. Factors affecting currency substitution and the impact of currency substitution on basic macroeconomic variables are analysed econometrically after a theoretical background discussion on the emergence of currency substitution, and its forms and macroeconomic impacts. Currency substitution which was treated in the literature for developed countries during seventies, emerged as a problem for developing countries during eighties. Currency substitution leads inefficiencies in monetary and exchange rate policies, losses in seigniorage and inflation tax and a negative impact on the real economy in a country. EU countries pegged their currencies to each other as a first step, and then inaugurated currency union thus removed currency substitution and its negative impacts. Currency substitution which is major problem for both developing and developed countries is studied within the context of Turkey in the post 1980 era. Currency substitution in Turkey and contributing factors are analysed by the method of least squares. According to the analysis, it is concluded that the rate of currency substitution increases as a result of the expectations for higher inflation and exchange rates, and rises in money supply; decreases as interest rates and İMKB index increase. It is also found that most sensitive variables of currency substitution are changes in inflation and exchange rates. It is also concluded that currency substitution causes increases in the velocity of money and exchange rates but decreases in seigniorage, an important public income. It seems that it is a very important item on Turkey's agenda preventing currency substitution in order to reaffirm trust on the national currency when negative effects of currency substitution on the real economy and the excess demand for hard currencies during the 2001 financial crisis are considered. The fact that expectations toward higher inflation and exchange rate fuels currency substitution, leads us to think that it will be prevented to a large extent by a successful anti- inflationary programme. The existence of a powerful and trusted national currency is closely related with the economic and political stability.