Currency substitution and the transactions demand for money

Currency substitution – the use of foreign money to finance transactions between domestic residents – is increasingly common in low income and transition economies. Traditionally, however, empirical models of the demand for money tend to concentrate exclusively on the other dimension of dollarization, namely the wealth, or portfolio, motive for holding foreign currency, while maintaining the assumption that the income elasticity of demand for domestic money is constant. We offer a simple re-specification of the demand for money which more accurately reflects the process of currency substitution by allowing for a variable income elasticity of demand for domestic money. This specification is estimated for Vietnam in the 1990s. Using a standard cointegration framework we find evidence for currency substitution only in the long-run but well-defined wealth effects operating in the short-run.