Foreign Inflation Transmission under Flexible Exchange Rates and Currency Substitution

Abstract

The dynamic and steady-state effects of a permanent, unanticipated increase in foreign inflation on a small open economy are analyzed under flexible exchange rates and currency substitution. The velocity of domestic money, and consequently the domestic inflation rate, may rise along the transition path to steady state, but only if demand for foreign currency is sufficiently elastic such that the substitution from foreign to domestic money on impact is large. Higher foreign inflation is transmitted negatively when demand is inelastic. All else constant, a higher initial level of foreign real balances increases the magnitude of the transmission effects. Copyright 1990 by Ohio State University Press.