Welfare Gains from Disination in an Economy with Currency Substitution

This paper builds a general equilibrium model with working capital and currency substitution and uses this model to assess welfare gains from disin‡ation. It is found that welfare gains from disin‡ation are higher when the baseline in‡ation rate and the elasticity of substitution between foreign currency and domestic deposits are higher. Indeed the gains from disin‡ation can be quite large compared previous studies especially for moderate rates of in‡ation if the two assets are highly substitutable under the baseline scenario. After the benchmark economy is speci…ed, the model is used to assess welfare gains from disin‡ation for a given level of …nancial development. The model implies that, higher currency substitution is welfare enhancing for high in‡ation rates but not for moderate and low in‡ation rates. In other words, currency substitution is not necessarily welfare enhancing.