CURRENCY SUBSTITUTION AND FOREIGN INFLATION*

According to traditional theory, flexible exchange rates may in-sulate a country from monetary disturbances originated in the rest of the world. This is true only if the residents of the country do not hold foreign currency. Where the possibility of substituting foreign currency for domestic currency exists, flexible exchange rates may no longer provide a cushion against external shocks [Chen, 1973; Miles, 1978]. The present paper proposes to show how an open economy in which residents hold foreign as well as domestic currency will be affected by a change in the rate of inflation abroad. In Section I a small country model of dual currencies is developed in the context of long-run steady-state-inflation equilibrium. Section II discusses how the domestic rate of inflation is affected by an increase in the rate of inflation abroad. Section III shows how the balance of trade is af-fected by a change in the foreign rate of inflation. The controversial issue of whether money is neutral or not in the context of dual cur