Currency Substitution and Exchange Rate Policy within the European Union

The notion of ‘currency substitution’ emerged in the 1970s as an indirect result of the collapse of the Bretton Woods fixed exchange rate system. Under a fixed exchange rate system the monetary authorities agree to buy and sell domestic currency at a fixed price, which effectively makes domestic and foreign currencies perfect substitutes on the supply-side. In the absence of peg adjustments domestic residents need not hold foreign currency since they can always purchase foreign currency at a pre-agreed price. Under floating exchange rates, however, where the price of foreign currency may vary, domestic residents may choose to hold domestic and or foreign currencies, according to their relative prices. That is, domestic residents (and indeed foreign residents) may choose to substitute foreign (domestic) money balances for domestic (foreign) money balances. In this case currency substitution occurs on the demand-side of the market. These keywords were added by machine and not by the authors. This process is experimental and the keywords may be updated as the learning algorithm improves.