The currency substitution model

This model is a continuation of the monetary model as it takes into account a country's investment flows. It basically says that changing private and public portfolios from one country to another can have a significant effect on exchange rates. As such, the ability of people to transfer their holdings from their local currency to foreign currencies is known as currency substitution. When this model is applied in conjunction with the monetary model, there is every reason to believe that the ups and downs of a country's capital supply expectations can have a significant effect on currency prices.

In this case, investors look for data on the exchange model and conclude that it is very likely that there will be a change in capital flows, which will have the effect of modifying the exchange rate. This is why they have come to invest, and it ends up transforming the monetary model into a self-fulfilling prophecy. Traders who subscribe to this theory usually end up becoming followers of the currency substitution model.

An example with the yen

When we talked about the monetary model, we explained that when it bought stocks and bonds on the market, the Japanese government was printing more yen, which led to an increase in the supply of that currency. Proponents of the monetary model can conclude that this increase in the money supply increases inflation, because there are more yen for a smaller number of products, which decreases the demand for this currency and eventually leads to its depreciation. Followers of the currency substitution model would probably agree with this assessment and, at the same time, try to take advantage of it, by opening short positions (selling) on the yen or by closing their long (buy) positions in this currency. Thus, a trader who trades the yen helps the market to move in this direction, which ends up validating the prediction of the monetary model. We can summarise the process as follows:

  • Japan starts to buy stocks and bonds on the market, so economists expect the supply of yen to increase significantly.
  • Meanwhile, economists expect a general increase in inflation after the implementation of the new policy. Traders therefore expect the yen exchange rate to fluctuate.
  • Interest rates are also expected to rise as inflation begins to rise. While this is happening, speculators are starting to open short positions on the yen as they expect this currency to start declining soon.
  • The demand for the yen is declining as more and more money enters the Japanese economy and traders are selling their yens on the market in droves.
  • Yen prices are quickly changing as their value is dropping against foreign currencies, especially those that investors can easily replace.

Main limits of the currency substitution model

Among the currencies with the highest transaction volumes at the international level, the currency substitution model doesn't yet show that it constitutes a single determinant of forex price movements. Although this model can be more reliably applied to the economies of underdeveloped countries where the more volatile cash flows in and out of these emerging markets have the greatest effect, there are still many variables that this model doesn't take into consideration.

For example, using the previous example with the yen, we can say that although Japan can generate inflation through its policy of buying stocks and bonds, it continues to post a very large current account surplus. Likewise, this country is involved in many political situations in its region which should be avoided, so if Japan hints that it intends to devalue its currency, this could entail serious consequences. The fact is that these are just two of the many factors that this model ignores. Despite this, the currency substitution model should be seen as part of a set of tools that can be used to analyse the forex.

Summary - Interest rate forecasts according to economists