On the Missing Link between Currency Substitution and Crises

Traditional approaches to the etiology of financial crises focus on the fundamentals of an economy, more specifically on the disequilibrium in the balance of payments. The purpose of this paper is to extend this ‘first generation’ literature of financial crises with a general model that focuses on the quality of a currency as a store of value for asset holding purposes – as opposed to the medium-of-exchange characteristics of a currency that enter considerations of the balance-of-payments approach. A formal model is sketched around a utility function that includes money as an asset held in both local currency and foreign exchange. Given a steady stream of money supply, asset-price considerations in a free currency market make a fixed exchange rate untenable for the local currency and lead to devaluation and to crisis. Impressionistic evidence from the recent experience of financial crises corroborates the hypothesis of currency substitution. The policy implications of the hypothesis parallel those f market incompleteness for asymmetric information, as cast within the framework of asymmetric reputation between the soft and hard currency that leads to currency substitution for asset-holding purposes