The Real Effects of Foreign Inflation in the Presence of Currency Substitution

The paper explores optimizing models of small open economies that hold foreign money balances. Particular attention is paid to the impact of foreign inflation on the real exchange rate and other real variables. At first, an environment in which foreign money is the only traded asset is explored. This is compared to a more general setting in which many assets can be traded. The effect of foreign inflation on domestic real variables depends on: 1) the degree to which it causes a substitution out of traded assets as a whole and into non-traded assets, and 2) the change in real returns on the portfolio of traded assets held by domestic residents.