Dollarization and the demand for money in Egypt

This dissertation examines the demand for domestic and foreign money by residents in Egypt. Previous studies on the demand for foreign currency denominated deposits in Egypt, claim to have found currency substitution. However, the Egyptian financial system has been characterized by interest rate ceilings, exchange rate controls, and high rates of inflation that brought about negative real rates of return on domestic assets. In addition, underdeveloped money and capital markets, as well as, controls on capital flows, imply that the available asset menu is very limited. Consequently, foreign money is the only alternative liquid form of financial wealth. That is, foreign money is not dominated by other interest-bearing assets and, therefore, is held primarily as a store of value (dollarization) rather than as a medium of exchange (currency substitution). This implies that the increase in foreign money in Egypt may have been caused by portfolio shifts in response to differentials in rates of return. Modifying Cuddington's portfolio balance approach and using an error correction model, the demand for domestic and foreign money are tested for the period 1981:I-1993:IV. The results indicate that there is a negative (positive) relationship between the expected rate of return on foreign money and the demand for domestic (foreign) money. The results, while not conclusive due to missing data problems, support the predominance of portfolio (dollarization) over transactions considerations (currency substitution). In addition, contradicting previous findings, these results imply that Egyptian residents take the rates of return on foreign money rather than expected depreciation into account as part of the opportunity cost of holding money. To check the robustness of these results variance decompositions and impulse response function are examined. The results indicate that the expected rate of return on foreign money is more informative than expected depreciation about future movements of the demand for domestic and foreign money. The policy implication contained in these results is: when estimating a money demand to assess monetary policy, foreign money should not be included in monetary aggregates.