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 m otive for foreigners to hold domestic currency. It uses time-series and cro ss-sectional information for a panel of 17 industrialized countries testing two-way fixed-effects models against pooled and random-effects alternative s. The cross-sectional information is significant, revealing that pooling o f data could result in misleading inferences, since country-specific effect s, regional group effects, and distance are all important determinants of d omestic currency holding by foreigners. (JEL F41, F36, F14).