Discussion Paper Series The Effects of Uncertainty on Currency Substitution and Inflation: Evidence from Emerging Economies

This paper examines the effects of inflation and currency substitution volatility on the average rates of inflation and currency substitution for twelve emerging market economies. Using a bivariate GARCH-in-Mean model, which accommodates for asymmetric and spillover effects of inflation and currency substitution innovations on their volatilities, we find that for the majority of the countries in the sample the variability of inflation exerts a positive influence on both the average rates of inflation and currency substitution. Similarly, higher uncertainty in currency substitution displays enhancing effects on inflation and currency substitution. These results indicate an alternative avenue that stresses the importance of currency substitution for the conduct of monetary policy in terms of price stability, and provide an additional explanation to the phenomenon of dollarization hysteresis. JEL Classification: C32; E31; E52; F31 ∗ We are grateful to Denise Osborn, Len Gill and Ralph Becker for helpful discussions and comments on a previous draft.