  This paper investigates and compares currency substitution between the
currencies of Central and Eastern European (CEE) countries and the euro. In
addition, we develop a model with microeconomic foundations, which identifies
difference between currency substitution and money demand sensitivity to
exchange rate variations. More precisely, we posit that currency substitution
relates to money demand sensitivity to the interest rate spread between the CEE
countries and the euro area. Moreover, we show how the exchange rate affects
money demand, even absent a currency substitution effect. This model applies to
any country where an international currency offers liquidity services to
domestic agents. The model generates empirical tests of long-run money demand
using two complementary cointegrating equations. The opportunity cost of
holding the money and the scale variable, either household consumption or
output, explain the long-run money demand in CEE countries.
