DEFINITION of 'Currency Substitution'

The use of a foreign currency in transactions in place of the domestic currency. The foreign currency thus serves as a medium of exchange. Countries using flexible exchange rates can experience problems if there is a high rate of currency substitution because they can no longer control all currency types through monetary policy. The higher the rate of currency substitution, the greater the likelihood of monetary disturbances caused by changes in the foreign currency.

BREAKING DOWN 'Currency Substitution'

A country may choose to use flexible exchange rates rather than fixed exchange rates in order to mitigate the effect of foreign currency fluctuations on the domestic currency and economy. An increase in the rate of currency substitution means that the domestic economy can fall victim to rapid changes in exchange rates, and thus may experience monetary increased shocks from both home and abroad.

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