The micro-foundations of an open economy money demand: An application to the Central and Eastern European countries

TL;DR

This paper develops a microeconomic model to analyze currency substitution and money demand sensitivity to exchange rates in Central and Eastern European countries, highlighting the role of interest rate spreads and exchange rate effects.

Contribution

It introduces a novel micro-founded model distinguishing currency substitution from money demand sensitivity to exchange rates, applicable to countries using international currencies.

Findings

Currency substitution relates to interest rate spread sensitivity.

Exchange rates influence money demand independently of substitution.

Long-run money demand explained by opportunity cost and scale variables.

Abstract

This paper investigates and compares currency substitution between the currencies of Central and Eastern European (CEE) countries and the euro. In addition, we develop a model with microeconomic foundations, which identifies difference between currency substitution and money demand sensitivity to exchange rate variations. More precisely, we posit that currency substitution relates to money demand sensitivity to the interest rate spread between the CEE countries and the euro area. Moreover, we show how the exchange rate affects money demand, even absent a currency substitution effect. This model applies to any country where an international currency offers liquidity services to domestic agents. The model generates empirical tests of long-run money demand using two complementary cointegrating equations. The opportunity cost of holding the money and the scale variable, either household consumption or output, explain the long-run money demand in CEE countries.