Currency Substitution and Currency Crises

This paper investigates the relationship between the collapse timing of exchange rate regime and degree of substitutability of foreign currency for domestic currency as a medium of exchange. According to the spirit of Chen et al. (1981), Tsaur (1987), Chang et al. (1991), we set up a transaction-based monetary model in which money provides liquidity services to reduce transaction costs, domestic and foreign currencies are introduced into the system. The results of study showed (1) no matter what degree of substitutability of foreign currency for domestic currency, the collapse timing of the exchange rate regime is earlier than the natural collapse timing, and (2) the collapse timing depends on the degree of currency substitution or complement. We found that the extreme degree of substitutability of currencies led to earlier currency crisis; however, moderate degree of substitutability of currencies postponed currency crisis. We also explored the dynamic transition process from the fixed to the crawling peg, and then to the flexible exchange rate regimes. We found that the extent of the decrease in foreign exchange reserves is the key whether the fixed exchange rate is able to transform into the crawling peg exchange rate regime.