The dynamics of inflation and currency substitution in a small open economy

Abstract

This paper analyzes the relationship between money and inflation in a small open economy, where domestic and foreign currencies are perfect substitutes as means of payment. It is shown that, if the path of domestic money supply is such that individuals find it optimal to change the currency in which transactions are settled, there will be an adjustment period during which domestic inflation adjusts to equal the foreign inflation rate. The model captures the stylized fact that temporary increases in the inflation rate may have permanent effects in the use of foreign currency, even without the introduction of dollarization costs.