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contrast with the fixed exchange rate system in which each country’s money supply was
endogenous, it is determined exogenously by monetary authorities. Under flexible rates,
the balance of payments is always zero, i.e. there is no net money flow between central
banks. Flexible rates therefore make currencies perfect non-substitutes on the supply side.
However, the insular property of floating exchange rates may break down when there is
currency substitution. Some investors might consider domestic and foreign currencies as
relatively close substitutes. Currency substitution suggests that the demand for domestic
money is dependent on external factors. If domestic residents hold portfolios containing
both foreign and domestic assets and reallocate these portfolios according to changes in
the relative opportunity costs of these assets, foreign monetary shocks will alter the
relative costs of holding a given portfolio. This in turn induces residents to reallocate
their portfolios between domestic and foreign assets. The readjustment of currency
holdings enables monetary shocks to be transmitted via money demand from one
economy to another even in a world of flexible exchange rates.
In addition, Rüffer and Stracca (2006) argue that apart from currency substitution
money has to be characterized as endogenous. For this purpose, they modify the standard
portfolio balance model by assuming that the key rate of the central bank is exogenous
and domestic money holding is endogenous, i.e. money-demand driven (and dependent
on foreign interest rates, as investors hold foreign bonds). Hence, one can think of direct
spillover effect in monetary aggregates from abroad if the national money supply is
endogenous, i.e. driven by money demand and not by money supply via central banks.
Consider the case of an expansionary monetary policy in the foreign country
which we capture by a reduction in foreign interest rates. As a first consequence, foreign
investors shift out of foreign bonds and into foreign money due to the reduced
opportunity costs of monetary balances. As a second step, the reduction in foreign interest
rates raises the relative attractiveness of domestic money and bonds for domestic agents.
If the elasticity of the demand for money with respect to the foreign interest rate is larger
than the elasticity of the demand for domestic bonds, then the money holdings in the
domestic country increase.