A cross-country panel analysis of currency substitution and trade

Attention that has been directed toward the effect of trade on foreigner's holdings of domestic currency comes exclusively from time-series evidence. Here we extend a model of currency substitution that incorporates a trade motive for foreigners to hold domestic currency. It uses time-series and cross-sectional information for a panel of 17 industrialized countries testing two-way fixed-effects models against pooled and random-effects alternatives. The cross-sectional information is significant, revealing that pooling of data could result in misleading inferences, since country-specific effects, regional group effects, and distance are all important determinants of domestic currency holding by foreigners. (JEL F41, F36, F14).