Understanding the welfare implications of currency substitution

This paper develops a model of endogenous currency substitution where agents decide which purchases will be made with domestic and which with foreign currency. In a representative agent economy allowing for this use of alternative means of payments is welfare enhancing. The result is an application of Ramsey taxation rules, by which currency substitution shifts the burden of the inflation tax towards relatively demand inelastic commodities. When extending the model to the case in which agents have different productivities we show that inflation has strong income distribution effects with high (low) income agents benefitting (losing) when currency substitution is introduced.