The Hysteresis Effect of Currency Substitution in Iran: Divisia Index Approach

This study examines the hysteresis effect of currency substitution in Iran using a model of money-in-the-utility function with two currencies (home and foreign). In this respect, Divisia monetary aggregates has been used for calculating the dollars in circulating. The bounds testing approach to the analysis of level relationship proposed by Pesaran et al. (2001) and Autoregressive Distributed Lag (ARDL) model have been used for Iranian quarterly data during 1990- 2014. The results indicate that there is evidence supporting the existence of the hysteresis effect of currency substitution in Iran. In other words, currency substitution process is irreversible. Therefore, it is suggested that the central bank consider the effect of the hysteresis of dollarization phenomenon on monetary policy and the purpose of controlling inflation and reducing exchange rate volatility as the main reasons of currency substitution, continues to be a priority for economic policy.