Variation in the real exchange rate as a source of currency substitution

This paper presents a 'shopping cost' money service model in which it is shown that the real exchange rate influences the desired ratio of domestic-to-foreign-currency bank deposits. Empirically, it is found that if the real exchange rate value of the Canadian dollar falls then US dollar deposits of Canadians rise relative to Canadian M2. This relationship is found to be cointegrated. Dynamic adjustment analyzed using an error correction model indicates a cyclical adjustment. The results provide evidence that variation in the real exchange rate is a source of currency substitution and reinforces the argument that demand side factors influence the money stock.