Introduction: from the policy questions to the theory

In Europe the issue of currency substitution has surfaced in the debate on monetary policy and economic and monetary union (EMU). The main concern is that the liberalization of financial and goods markets can bring about instabilities in money demand with undesirable side effects.

The removal of capital controls has eliminated restrictions on holdings of liquid assets in foreign currency by the residents of countries in the European Community (EC). A noticeable increase in cross-border deposits, documented for example by Angeloni, Cottarelli and Levy (1991), has accompanied the financial liberalization.

The increase in cross-border deposits raises two separate questions. The first, discussed especially by Angeloni et al., concerns the statistical definition of monetary aggregates. If monetary aggregates used by central banks for policy design and implementation do not include a large and growing stock of cross-border deposits, the control problem of the monetary authorities can be made more difficult. Suppose, for example, that a stable demand relationship exists between the ‘true’ monetary aggregates (which include, in some appropriate way, cross-border deposits) and observable variables. But suppose central banks, in their day-to-day management, use monetary aggregates that do not include cross-border deposits. Then the stability of the aggregate used by central bankers depends on the stability of the stock of cross-border deposits.