Exchange Rate Dynamics with Currency Substitution: the Case of Ghana, Paraguay and Uruguay

This paper presents a monetary exchange rate model with imperfect capital mobility, slow adjustment of goods prices in the short-term and currency substitution. As in Dornbusch’s model (1976), it is demonstrated that an exogenous monetary shock can lead to an initial overshooting of the exchange rate. In our model, this phenomenon derives from the presence of currency substitution. This model is illustrated with reference to three developing countries, Ghana, Paraguay and Uruguay, using quarterly data covering the period of independently floating exchange rate regime for each of them. At least one co-integrating vector between the exchange rate and its determinants is identified, lending support to the interpretation of the monetary exchange rate model as describing a long-run phenomenon. We estimate error-correction models to investigate the adjustment process to the long-run equilibrium. We find without ambiguity an overshooting phenomenon in the short-run in the case of Uruguay. For the two others countries, the results are mixed.