The inflation discipline of currency substitution

Abstract

We examine the argument that currency substitution should be encouraged since it provides an inflation discipline. In highly stylized games of national welfare maximization, we find that as currency substitution increases, currency survival comes to dominate all other considerations, and inflation rates do indeed come down. However, we find no reason to think that these competitive inflation rates will be optimal. The discipline embodied in currency substitution may be too weak, or too strong. It may be a poor substitute for direct coordination of monetary (and fiscal) policies. We try to relate our analysis to recent U.K. proposals. © 1992.