Monetary versus fiscal policy under currency substitution: empirical analysis

We investigate the relative effectiveness of monetary and fiscal policy under currency substitution in emerging economies using Vector Autoregressive (VAR), Factor Augmented Vector Autoregressive (FAVAR), and Granger causality frameworks. The central question is whether currency substitution weakens monetary policy transmission to the extent that alternative policy tools become more effective. We analyse monthly and quarterly time-series data from Peru (1995–2020) and Cambodia (2008–2019). Our results show that monetary policy transmission weakens as the degree of currency substitution increases, while improving as currency substitution declines. However, even in periods of relatively low currency substitution, fiscal policy remains more effective than monetary policy in influencing real economic activity. Overall, the findings highlight the persistent importance of fiscal policy as a stabilization tool in economies affected by currency substitution.