Currency substitution, inflation, seignorage and welfare : The Case of Cambodia

This paper aims at examining the declining inflation rate, the shape of the Laffer curve, welfare and Seignorage-optimizing inflation rate in a small open economy with flexible prices and exchange rate, under currency substitution. The model shows that, in the steady state, the equilibrium demand for foreign and domestic real balances is not a stable equilibrium. However, the model shows that there is a positive relationships between the demand for domestic and foreign real balances. In the empirical section, It is found that the higher the ratio of foreign currency deposit (FCD) to narrow or broad money supply, the lower the inflation rate and that the domestic inflation rate converges to foreign inflation rate which is lower than the domestic inflation rate.