Silviase/jgov_v1.4_full_ann huggingface dataset:
precipitates a devaluation that may turn into a financial crisis. The analytical distinction between the two approaches lies in the economic function of money that has been incorporated in each. By focusing on the balance of payments, the extant models of financial crises consider the function of money as a medium of exchange in the (international) market for goods and services. The currency substitution hypothesis considers also the role of money as a store of value. While all currencies can do service, better or worse, for transaction purposes, when used as store of value they are ranked in a definite pecking order from the reserve/hard, to the soft, and to the worthless currency in a decreasing order of usefulness. There is a positional continuum in holding currency as an asset based on its reputation. Reputation in this specific case means that there is a credible commitment to stability of currency prices relative to some other prices that matter – and this commitment is more credible, the closer a currency is to the reserve currency. Their inherent asset value places reserve currencies in central banks' reserves, and also makes them safe havens for international capital movements. By the same token, the demand for foreign exchange – and especially for reserve and hard currencies - becomes an important component in a representative agent's utility function regardless of the motivation for holding such assets, whether it is for portfolio diversification, speculation or hedging.

The underlying asymmetry in reputation between soft and hard currency implies a corresponding asymmetry in the determination of their respective exchange parities in a free currency market. While transactions demand for foreign exchange is the principal determining factor of the price of both hard and soft currencies, in the case of the latter the demand for foreign exchange for asset-holding purposes plays an important role in decreasing the price of the currency (devaluation) and in exacerbating exchange rate instability. Asymmetrically, the same demand by a soft-currency country drives the price of the hard currency to appreciation – and appreciation, if it becomes problematic, is easier to combat than depreciation. Soft currencies, as a result, are likely to be more “undervalued” (and more difficult to remedy) than hard currencies that may tend to become “overvalued”. Herein lies the emblematic difference between the currency substitution hypothesis and the extant interpretations of currency crises. In the mainstream view devaluation always retains its salutary healing effects by matching supply and demand and storing up the current account, thus eventually improving the fundamentals. In the currency substitution alternative, on the other hand, devaluation will increase the value of the parameter $ \partial\alpha_{t}/\partial z_{t+1}^{e}>0 $ (in Section 3.4) thus leading to an increased demand of foreign exchange for asset holding.
purposes. In this view, competitive price-setting of foreign exchange for a soft currency represents “bad competition” and can lead to “a race for the bottom,” i.e., to further serial devaluations. It becomes intuitively clear that this interpretation of the foreign exchange market for a soft currency amounts to a market incompleteness because of asymmetric reputation. This case corresponds fully to the parallel literature of incomplete credit markets for reasons of asymmetric information (Stiglitz and Weiss, 1981). The empirical implications of the two types of market incompleteness are also concordant. The policy implication of rationing foreign exchange and imposing a mildly repressed exchange rate replicates the need for credit controls for circumventing the “bad competition” and the “race for the bottom” that competitive price-setting implies for the credit market. Capital controls become expedient in the case of an incomplete foreign exchange market only to the extent that the inflow of financial capital contributes to fanning (cheap) currency substitution of the soft local currency. Otherwise, there is no need for imposing restrictions on direct foreign investment inflows or on outflows for the purpose of settling current account imbalances, or of repatriation of capital and profits (Yotopoulos, 1996, 1997; Yotopoulos and Sawada, 1999).

The case of speculative attacks on a currency, as made in the literature, is related to financial capital flows in the form of “hot money.” This is a special case of the currency-substitution-induced devaluation in the model where unregulated inflows of financial capital can increase the value of the parameter $ \alpha_{t} $ . In a free currency market, where devaluation may happen, or it may not, the holder of the soft currency is offered a one-way-option: by substituting the hard currency for the soft, there is a capital gain to be reaped if devaluation happens, while there is not an equivalent loss if it does not. This one-way bet is also offered to the “speculator” who can sell short the soft currency. It is especially attractive to foreign fund managers who can borrow the soft currency locally by leveraging a few million dollars’ deposit into a peso loan with the proceeds, in turn, converted into dollars. This play of draining the Central Bank’s reserves makes the devaluation of the peso a self-fulfilling prophecy. And when devaluation comes, the international investor can pay back the loan in cents on the dollar and take his hot money across the Rio Grande. $ ^{17} $ The entire process is initiated by taking advantage of the free currency
market to convert a soft-currency monetary asset into hard currency, thus asymmetrically increasing the asset-demand for the latter and leading to the depreciation of the former.

The testable implication of this view of the role that financial capital can play in devaluations and financial crises relates to the timing of capital outflow. The currency substitution hypothesis would predict that the outflow of capital takes place after the devaluation happens and once the capital gains from selling the soft currency short have been captured. This expectation is confirmed from IMF data indicating that in the case of the East Asian crises the outflow of capital happened in the fourth quarter of 1997, instead of the third quarter when the crises were being staged. In the final quarter of 1997 the flight of capital from Korea amounted to $89 billion, or 18.9 percent of GDP, compared to a net inflow of capital of 0.7 percent of GDP for the third quarter. The same pattern held for the other crisis-countries also (in percent of GDP, with the third quarter figures in parentheses): Indonesia, -15.8 (3.3); Thailand -22.1 (-15.1); the Philippines -6.1 (9.0) – with Malaysian data lacking due to the exchange and capital controls that were imposed in August 1997 (Cho and Rhee, 1999; Yotopoulos and Sawada, 1999).

The literature advocating capital controls has emphasized the unpredictability of international financial flows that consist largely of short-term bank deposits where a sudden reversal of the inflows may quickly result in bank insolvencies and failures (e.g., Calvo, Leiderman, Reinhart, 1993). The policy recommended for controlling financial capital inflows envisions racheting the reserve requirements up to 100 percent for the shortest-maturity capital flows. The cost of dis-intermediation in capital flows that this intervention entails is more than offset by decreasing banks' exposure. In the currency-substitution view such intervention prevents the formation of an avalanche of one-way-options against the soft currency that is bound to lead to a financial crisis. Thus the cost of disintermediation in capital flows is further decreased.

Financial capital flows notwithstanding, the use of reserve requirements as an appropriate financial-sector reform has been widely discussed in the literature (Cole and Slade, 1998; Calvo,
Leiderman, and Reinhart, 1993). Inappropriately low reserve requirements encourage domestic banks to undertake risky projects that ultimately may result in bank insolvencies. On the other hand, prudent reserve requirements contribute to reducing the risks of private banks through imposing high capital-to-risk-asset ratios and thus inducing banks to hold low-risk assets. Moreover, the central bank can use the rent created by reserve requirements to cover capital deficiencies in the event that banks became insolvent and need arises to have them be merged, sold, or liquidated. Such policy recommendations are consonant with the model of currency substitution that champions a conservative fiscal and monetary policy for avoiding a currency-substitutio n-led devaluation. To verify the importance of this intervention note that a lower money multiplier will put off the timing of the collapse of the fixed exchange rate regime since $ \partial T/\partial\mu < 0 $ . Recall that the money multiplier is defined as $ \mu = (c+1)/(c+r_{D}+d) $ , where c, $ r_{D} $ , and d represent the currency-deposit ratio, the required reserve ratio, and the excess reserve-deposits ratio, respectively. Therefore, we can easily see that increasing the required reserve ratio will postpone the BOP crisis.

### 6. Conclusions

Since 1980 three-quarters of member-countries of the IMF, developed, developing, and emerging alike, have been hit by financial crises. In the 1990s financial crises became especially virulent occurrences. The “fundamentals” models of financial crises can still do service in explaining financial crises only with an increasing dose of willing suspension of disbelief.

This paper extends the first-generation models of financial crises to allow for a systematic devaluation of soft currencies that is independent of the fundamentals of an economy. In a globalized world of free foreign exchange rates and free capital movements, the demand for racheting up the quality of a currency used as an asset increases. Currency substitution in favor of the reserve currency (currencies) becomes an exogenous factor relating to currency as a positional good, and leads to systematic devaluation of the soft currency – and eventually to crises.

The seemingly simple extension that we introduce into the “fundamentals model” of financial crises has empirical and policy implications that can prove germane in approaching “speculative attacks” on currencies and in assessing the dioramas for the “new architecture” of the international financial
system. In the fundamentals approach to financial crises devaluation has remedial effects on the balance of payments and a transfusion of foreign capital helps shore up the reserves of the central bank and restore confidence in the currency. Devaluation and fresh capital inflows are the remedies to financial crises. In our extension of the fundamentals model, on the other hand, devaluation can be the validation of systematically substituting in liquid asset-holdings the foreign currency for the domestic. Should this be the case, devaluation will further increase the tendency for currency substitution; and emergency lending for shoring up the currency is likely to end up in portfolio of maximizing agents, whether under the mattress or in foreign tax havens. In the latter case abrogating the free currency market for asset-holding purposes is an orthodox macroeconomic tool that can stymie the tendency of “speculators”, let alone of local kleptocrats, to funnel emergency loans of foreign exchange into their offshore bank accounts.
## Appendix A: derivation of the first-order conditions

We can solve the maximization problem of (1) subject to the intertemporal budget constraint by setting up the following Lagrange function:

$$ \begin{align*}L_{t}=\sum_{s=t}^{\infty}\rho^{s-t}\Biggl\{\theta u(C_{s})+(1-\theta)\Biggl[\gamma\log\Biggl(\frac{M_{1s}}{P_{s}}\Biggr)+(1-\gamma)\log\Biggl(\frac{\pmb{\varepsilon}_{s} M_{Fs}}{P_{s}}\Biggr)\Biggr]\Biggr\}\\+\sum_{s=t}^{\infty}\lambda_{s}\Biggl[(1+r)B_{s}+\frac{M_{1s-1}}{P_{t}}+\frac{\pmb{\varepsilon}_{s} M_{Fs-1}}{P_{s}}+Y_{t}-C_{t}-B_{s+1}-\frac{M_{1s}}{P_{t}}-\frac{\pmb{\varepsilon}_{s} M_{Fs}}{P_{s}}\Biggr],\end{align*} $$

where $ \lambda $ 's denote Lagrange multiplier. Then we obtain the following first-order conditions with respect to $ C_{t} $ , $ C_{t+1} $ , $ B_{t+1} $ , $ M_{1t} $ , and $ M_{Ft} $ , respectively:

$$ \theta u^{\prime}(C_{t})=\lambda_{t}, $$

$$ \mathsf{\rho}\theta u^{\prime}(C_{t+1})=\lambda_{t+1}, $$

$$ (1+r)\lambda_{_{t+1}}=\lambda_{_{t}}, $$

$$ \frac{(1-\theta)\gamma}{M_{_{1t}}}+\frac{\lambda_{_{t+1}}}{P_{_{t+1}}}-\frac{\lambda_{_{t}}}{P_{_{t}}}=0, $$

$$ \frac{(1-\theta)(1-\gamma)}{M_{_{F t}}}+\frac{\lambda_{_{t+1}}\varepsilon_{_{t+1}}}{P_{_{t+1}}}-\frac{\lambda_{_{t}}\varepsilon_{_{t}}}{P_{_{t}}}=0. $$

Combining (A2), (A3), and (A4), together with no-consumption tilting condition, $ (1 + r)\rho = 1 $ , we have a standard Euler equation.

$$ u^{\prime}(C_{t})=u^{\prime}(C_{t+1}). $$

We can rewrite (A5) by using (A2), (A3), and (A7):

$$ \frac{(1-\theta)\gamma}{M_{_{1t}}}+\frac{\mathsf{\rho}\theta u^{\prime}(C_{_{t}})}{P_{_{t+1}}}-\frac{\theta u^{\prime}(C_{_{t}})}{P_{_{t}}}=0\;, $$

This equation (A8a) gives the domestic money demand function:

$$ \frac{M_{1t}}{P_{t}}=\left(\frac{1-\theta}{\theta}\right)\gamma\left[u^{\prime}(C_{t})\right]^{-1}\left(\frac{1+i_{t+1}}{i_{t+1}}\right), $$

where i is nominal interest rate, i.e., $ i_{t+1} = (1+r)(P_{t+1}/P_t)-1 $ . Similarly, from (A6) combined with (A2), (A3), and (A7) we obtain

$$ \frac{(1-\theta)(1-\gamma)}{M_{_{Ft}}}+\frac{\mathsf{\rho}\theta u^{\prime}(C_{_{t}})\boldsymbol{\varepsilon}_{_{t+1}}}{P_{_{t+1}}}-\frac{\theta u^{\prime}(C_{_{t}})\boldsymbol{\varepsilon}_{_{t}}}{P_{_{t}}}=0. $$

which gives the foreign money demand function as follows:

$$ \frac{\varepsilon_{t}M_{F t}}{P_{t}}=\left(\frac{(1-\theta)}{\theta}\right)(1-\gamma)\big[u^{\prime}(C_{t})\big]^{-1}\left(\frac{1+i_{t+1}}{i_{t+1}-z_{t+1}}\right) $$

where $ z_{t+1} $ is (future) devaluation rate, i.e., $ \varepsilon_{t+1}/\varepsilon_{t}=1+z_{t+1} $
Appendix B: derivation of the currency substitution variable

Combining equations (A8b) and (A9b) yields

$$ \boldsymbol{\alpha}_{t}=\frac{\boldsymbol{\varepsilon}_{t}\boldsymbol{M}_{_{F t}}}{\boldsymbol{\varepsilon}_{t}\boldsymbol{M}_{_{F t}}+\boldsymbol{M}_{1t}}=\frac{\frac{1-\gamma}{i_{t+1}-z_{t+1}}}{\frac{1-\gamma}{i_{t+1}-z_{t+1}}+\frac{\gamma}{i_{t+1}}}=\frac{(1-\gamma)i_{t+1}}{i_{t+1}-\gamma z_{t+1}}, $$

where $ i_{t} $ is the nominal interest rate, which is defined by the following expression: $ i_{t+1} = (1+r)(P_{t+1}/P_{t})-1 $ . We can easily show that $ \partial\alpha_{t}/\partial z_{t+1} > 0 $ , indicating that exchange rate devaluation will induce currency substitution under the assumption of sticky prices. What happens when the prices adjust instantaneously? To see this, we assume that the purchasing power parity (PPP) condition holds because of the instantaneous and complete price adjustments. In this case, we have $ P_{t} = \varepsilon_{t}P^{*} $ , where $ P^{*} $ is the foreign price level which is assumed to be constant to avoid unnecessary complications, while our qualitative results will not change in the following relevant argument even if we assume that $ P^{*} $ is not constant. Then equation (5) becomes

$$ \alpha_{_{t}}=\frac{(1-\gamma)[(1+r)(1+z_{_{t+1}})-1]}{[(1+r)(1+z_{_{t+1}})-1]-\gamma z_{_{t+1}}}=\frac{(1-\gamma)[r+(1+z_{_{t+1}})]}{r+(1+r-\gamma)z_{_{t+1}}} $$

Then we can show that

$$ \begin{aligned}\frac{\partial\alpha_{t}}{\partial z_{t+1}}=&\frac{(1-\gamma)(1+r)}{r+(1+r-\gamma)z_{t+1}}-\frac{(1-\gamma)\left[r+(1+r)z_{t+1}\right]}{\left[r+(1+r-\gamma)z_{t+1}\right]^{2}}(1+r-\gamma)\\=&\frac{(1-\gamma)(1+r)\left[r+(1+r-\gamma)z_{t+1}\right]-(1-\gamma)\left[r+(1+r)z_{t+1}\right](1+r-\gamma)}{\left[r+(1+r-\gamma)z_{t+1}\right]^{2}}\\=&\frac{(1-\gamma)\left\{(1+r)\left[r+(1+r-\gamma)z_{t+1}\right]-\left[r+(1+r)z_{t+1}\right](1+r-\gamma)\right\}}{\left[r+(1+r-\gamma)z_{t+1}\right]^{2}}\\=&\frac{(1-\gamma)\left\{(1+r)r-r(1+r-\gamma)\right\}}{\left[r+(1+r-\gamma)z_{t+1}\right]^{2}}\\=&\frac{(1-\gamma)r\gamma}{\left[r+(1+r-\gamma)z_{t+1}\right]^{2}}>0\end{aligned} $$

This comparative statics result indicates that currency substitution is induced by (future) devaluation. Facing fears of depreciation of the foreign exchange rate, households optimally switch their domestic currency to foreign currency, in order to maximize their intertemporal utility.
## Appendix C: proof of the proposition 1

The above comparative statics results hold in general, regardless of the speed of price adjustment. It is summarized by the following proposition:

Proposition 1 (Devaluation-induced Currency Substitution): Regardless of the adjustment speed of goods prices, a (future) devaluation induces currency substitution unambiguously.

Proof: Let $ \omega $ represents the speed of goods price adjustments, where $ 1 \geq \omega \geq 0 $ . Then, assuming $ P^{*} $ is constant, the domestic inflation rate in equation (3b) can be represented as a weighted average of devaluation rate and domestic inflation rate, i.e., $ P_{t+1}/P_{t} = (1 - \omega)(1 + z_{t}) + (1 - \omega)(P_{t+1}/P_{t}) $ . Note that $ \omega = 1 $ is the case of instantaneous price adjustment, while $ \omega = 0 $ represents the case of completely sticky price. In this case, the currency substitution parameter becomes:

$$ \alpha_{_{t}}=\frac{(1-\gamma)\{(1+r)[\omega(1+z_{_{t+1}})+(1-\omega)(P_{_{t+1}}/P_{_{t}})]-1\}}{\{(1+r)[\omega(1+z_{_{t+1}})+(1-\omega)(P_{_{t+1}}/P_{_{t}})]-1\}-\gamma z_{_{t+1}}}.\\ \mathrm{Let}\Pi_{_{t+1}}\equiv\omega(1+z_{_{t}})+(1-\omega)(P_{_{t+1}}/P_{_{t}}). $$

Then, it is straightforward to show that

$$ \begin{aligned}\frac{\partial\boldsymbol{\alpha}_{t}}{\partial z_{t+1}}=&\frac{(1-\gamma)(1+r)\boldsymbol{\omega}}{[(1+r)\boldsymbol{\Pi}_{t+1}-1]-\gamma z_{t+1}}-\frac{(1-\gamma)[(1+r)\boldsymbol{\Pi}_{t+1}-1][(1+r)\boldsymbol{\omega}-\gamma]}{\{[(1+r)\boldsymbol{\Pi}_{t+1}-1]-\gamma z_{t+1}\}^{2}}\\=&\frac{(1-\gamma)(1+r)\boldsymbol{\omega}\{[((1+r)\boldsymbol{\Pi}_{t+1}-1]-\gamma z_{t+1}\}-(1-\gamma)[(1+r)\boldsymbol{\Pi}_{t+1}-1][(1+r)\boldsymbol{\omega}-\gamma]}{\{[((1+r)\boldsymbol{\Pi}_{t+1}-1]-\gamma z_{t+1}\}^{2}}\\=&\frac{(1-\gamma)\{-(1+r)\boldsymbol{\omega}\gamma z_{t+1}+[(1+r)\boldsymbol{\Pi}_{t+1}-1]\gamma\}}{\{[((1+r)\boldsymbol{\Pi}_{t+1}-1]-\gamma z_{t+1}\}^{2}}\\=&\frac{(1-\gamma)[(1+r)(\boldsymbol{\Pi}_{t+1}\gamma-\boldsymbol{\omega}\gamma z_{t+1})-\gamma\}}{\{[((1+r)\boldsymbol{\Pi}_{t+1}-1]-\gamma z_{t+1}\}^{2}}\\=&\frac{(1-\gamma)\gamma\{(1+r)[\boldsymbol{\omega}+(1-\boldsymbol{\omega})(P_{t+1}/P_{t})]-1\}}{\{[((1+r)\boldsymbol{\Pi}_{t+1}-1]-\gamma z_{t+1}\}^{2}}>0,\end{aligned} $$

given $ z_{t+1} \geq 0 $ and $ P_{t+1} / P_{t} \geq 1 $ . Q.E.D.
## References

Agénor, Pierre-Richard (1994), “Credibility and Exchange Rate Management in Developing Countries,” Journal of Development Economics, 45 (October): 1-15.

Barro, Robert J. and David B. Gordon (1983), “Rules, Discretion and Reputation in a Model of Monetary Policy,” Journal of Monetary Economics, 12 (July): 101-121.

Blanchard, Oliver and Stanley Fischer (1989), Lectures on Macroeconomics. Cambridge, MA: MIT Press.

Baumol, William (1952), “The Transactions Demand for Cash: An Inventory Theoretic Approach,” Quarterly Journal of Economics, 66: 545-556.

Calvo, Guillermo A. and Carlos Végh (1996), “From Currency Substitution to Dollarization and Beyond: Analytical and Policy Issues,” in Guillermo A. Calvo, Money, Exchange Rates and Output. Boston, MA: MIT Press.

Calvo, Guillermo A., Leonardo Leiderman, and Carmen M. Reinhart (1993), “Capital Inflows and Real Exchange Rate Appreciation in Latin America,” IMF Staff Papers, 40 (1): 108-151.

Cavallari, Lilia and Giancarlo Corsetti (2000), “Shadow Rates and Multiple Equilibria in the Theory of Currency Crisis,” Journal of International Economics, 51: 275-286.

Cho, Yoon Je and Changyong Rhee (1999), “Macroeconomic Adjustment of the East Asian Economies after the Crisis: A Comparative Study,” Seoul Journal of Economics, 12 (winter): 347-389.

Clower, Robert W. (1967), “A Reconsideration of the Microfundamentals of Monetary Theory,” Western Economic Journal, 6: 1-19.

Cole, David C. and Betty F. Slade (1998), “The Crisis and Financial Sector Reform,” ASEAN Economic Bulletin, 15 (3): 338-346.

Eichengreen, Barry, Andrew K. Rose, and Charles Wyplosz (1994), “Speculative Attacks on Pegged Exchange Rates: An Empirical Exploration with Special Reference to the European Monetary System.” NBER Working Paper No. 4898.

Ernst & Whinney (various years), Foreign Exchange Rates and Restrictions.

Feenstra, Robert (1986), “Functional Equivalence between Liquidity Costs and the Utility of Money,” Journal of Monetary Economics, 17: 271-291.
Flood, Robert and Peter Garber (1984), "Collapsing Exchange Rate Regimes: Some Linear Examples," Journal of International Economics, 17(August): 1-13.

Flood, Robert and Nancy P. Marion (2000), “Self-fulfilling Risk Predictions: An Application to Speculative Attacks,” Journal of International Economics, 50: 245-268.

Frank, Robert H. (1985), Choosing the Right Pond. New York: Oxford University Press.

Frank, Robert H. and Philip J. Cook (1976), The Winner-Take-All Society: Why the Few at the Top Get So Much More Than the Rest of Us. New York: Penguin.

Girton, Lance and Don Roper (1981), “Theory and Implications of Currency Substitution,” Journal of Money, Credit and Banking, 13 (1): 12-30.

Giovannini, Alberto and Bart Turtelboom (1994), “Currency Substitution,” in Frederick van der Ploeg, ed., The Handbook of International Macroeconomics. Oxford: Basil Blackwell.

Hirsh, Fred (1976), Social Limits to Growth. Cambridge, MA: Harvard University Press.

Kareken, John and Neil Wallace (1981), “On the Indeterminacy of Equilibrium Exchange Rates,” Quarterly Journal of Economics, 96 (2): 207-222.

Keynes, John Maynard (1923), A Tract for Monetary Reform. New York: Macmillan.

Kravis, Irving B., Alan Heston and Robert Summers (1982), World Product and Income: International Comparisons of Real Gross Product. Baltimore, MD: Johns Hopkins.

Krugman, Paul R. (1979) “A Model of Balance-of-Payments Crises,” Journal of Money, Credit and Banking, 11: 311-25.

Lucas, Robert and Nancy L. Stokey (1987), “Money and Interest in a Cash-in-Advance Economy,” Econometrica, 55 (May): 491-513.

McKinnon, Ronald.I. (1979), Money in International Exchange. New York: Oxford University Press.

Obstfeld, M. (1996), “Models of Currency Crisis with Self-fulfilling Features,” European Economic Review, 40: 1037-1047.

Obstfeld, Maurice and Kenneth Rogoff (1996), Foundations of International Macroeconomics. Cambridge, MA: MIT Press.