Currency substitution and seigniorage-maximizing inflation: the case of Cambodia

Abstract

This article contributes a new empirical study on currency substitution in Cambodia. In our analysis, a model of money-in-the-utility function is adopted. The empirical results indicate that the elasticity of substitution between foreign and domestic real currency balances in Cambodia is high. Moreover, the high share of foreign real balances in providing domestic liquidity services in Cambodia is also confirmed by empirical analysis. Given these findings, the effects of the currency substitution on the government ability to gain from seigniorage revenue are also examined. The analysis from simulated results shows that the Cambodian government has little opportunity to gain from seigniorage revenue.

Acknowledgements

I would like to thank my academic supervisors, Akihisa Shibata and Tetsuro Shimamoto for their helpful comments and encouragements. The comments and suggestions from two anonymous referees of this journal are also gratefully acknowledged. I am solely responsible for any errors that may appear in this article.

Notes

¹ For detailed definition, see Calvo and Végh (1992).

² See, for example, Komárek and Melecký (2003) and Selçuk (1994, 1997, 2003). Due to the fact that currency substitution may affect the stability of money demand, over recent years, many researchers have taken into account the effect of currency substitution when estimating the money demand function. See, among others, Rodriguez and Turner (2003), Chaisrisawatsuk et al. (2004), Bahmani-Oskooee and Rehman (2005), Bahmani-Oskooee and Karacal (2006) and Wu and Hu (2007).

³ End of period annual data of International Financial Statistics published by IMF.

⁴ Viseth (2001) also adopted a simple model of MIU function as the theoretical background to identify his regression equation. However, the form of the utility function adopted by Viseth (2001) cannot be used to estimate the deep parameters.

⁵ MIU function is originally formulated by Sidrauski (1967). Sidrauski expanded the Ramsey optimal growth model by combining both consumption and real money balances in the utility function subject to the budget constraint which contains money. The model has been used widely for various studies in monetary economics. Sawada and Yotopoulos (2001) and Walsh (2003) provide good description and survey.

⁶ As there are no domestic bonds published in Cambodia yet, the individual is assumed to save in the form of foreign bonds. However, given the relatively less-developed financial system, assumption that individuals in Cambodia hold foreign bonds is a bit strong.

⁷ Most of the foreign balances circulating in Cambodia are US dollars. For this reason, the foreign balances, here, can be considered as US dollars.

⁸ See İmrohoroğlu (1994) for detailed calculation and description.

⁹ See İmrohoroğlu (1994) for detailed explanation.

¹⁰ The detailed explanation on the procedure for obtaining a consistent and efficient estimate for W_T is available in Hansen (1982).

¹¹ The period before 1998:07 is not considered because, during this period, the Cambodian economy was seriously affected by both internal and external shocks, especially the domestic political turmoil and the Asian financial crisis in mid-1997.

¹² The initial guess of the parameters is used to construct the initial estimate of the weighting matrix W_T in Equation 8. Some other initial values are also tried for robustness of the estimation.

¹³ See Calvo and Végh (1992, pp. 28–31), for detailed survey.

¹⁴ For simplicity, the population growth rate and the cost of printing money are not considered.

¹⁵ h, se and π are assumed to be the steady-state values of h_t , se_t and π _t , respectively.

¹⁶ The preferable form should be the form of utility function we used in Section II for our GMM estimation. The aim of this section is to numerically solve the optimization equations in the next subsection to find the seigniorage-maximizing inflation rate. However, if we adopt the form used in Section II, the optimization conditions cannot be solved explicitly. We have confirmed this by using solve function of MATLAB program. Thus, we employ the function adopted by İmrohoroğlu (1996) which is Equation 17. Selçuk (2001) also adopted this type of utility function to study the case of Turkey.

¹⁷ The detailed calculation is shown in İmrohoroğlu (1996).

¹⁸ Based on the ‘country reports’ released by IMF, in recent years, the percentage of annual total consumption of the Cambodian government on annual Gross Domestic Product (GDP) is around 15%.

¹⁹ We calculate this by using the annual data series of International Financial Statistics (IFS) published by IMF.