Macroeconomic determinants of currency substitution in Turkey

Abstract

Currency substitution exists in a country when a more stable foreign currency exists along with a domestic currency. Currency substitution effect exists when foreign currency in persistently held by domestic residents for transaction, speculative or precautionary purposes. Holding different currencies facilitates and reduces the costs of transactions and represents possible additional returns given by the rate of appreciation of the currency. Vegh (1989) stresses the transaction motive for holding foreign currency. It is argued that people find it more convenient to use dollars in their transactions due to the change in the exchange rate. Ortiz (1983) and Ramirez–Rojaz (1985) mention the precautionary motive for holding a foreign currency. People hold dollar-denominated financial assets in order to hedge themselves from the depreciation of domestic currency, which can be seen as precautionary motive for holding foreign currency.