Dollarization is the legal adoption of the U.S. dollar or another country’s currency as a second country’s own domestic currency. Some of the main reasons a country chooses dollarization are to gain more price stability and to eliminate sudden, sharp devaluations of the country’s exchange rate. However, when a country chooses to dollarize, it will give up control of its monetary and exchange rate policy, which limits its central bank’s ability to provide liquidity to banks and to stabilize the economy in a financial or economic downturn. Countries most likely to benefit from dollarization are those that are highly integrated with the U.S. in trade and financial relations.
Let’s take a closer look at what dollarization is, how it works, and the pros and cons of adopting it.
Definition and Examples of Dollarization
Dollarization refers to the adoption of the U.S. dollar as currency for all transactions in another country. In this setup, the dollar becomes the preferred currency for holding savings, making payments, and pricing goods.
Countries choose to adopt the U.S. dollar due to its long-term record of holding value, and because of global trust in the U.S. government that can help keep inflation low.
The term “dollarization” is also shorthand for the use of any foreign currency by another country.
An example of a country that has adopted the U.S. dollar as legal tender is Panama. It dollarized in 1904, although a national currency, the balboa, is used for small transactions. Panama’s decision to use the dollar as its official currency was based on strong political and economic ties to the U.S. Also, Panama has a unique location on a narrow strip of land between North and South America, which is a key trade route.
Two other Central American countries, Ecuador and El Salvador, have dollarized economies as well.
Dollarization contributes to greater economic integration due to low transaction costs during trade, because neither country needs to convert currency to buy goods. If the country adopts the U.S. dollar, or another widely accepted currency, it makes trade between the two countries—and sometimes others—quicker and cheaper.
How Does Dollarization Work?
Dollarization occurs when one country officially makes another country’s currency its legal tender. In an officially dollarized economy, the money supply works similar to that of the U.S. However, prices and money supply are determined by local preferences, and inflation rates can differ between the dollarized economy and the U.S.
For example, Panama and the U.S., while both using the U.S. currency, can have different inflation rates, similar to the way that Dallas and New York City can have differing rates of inflation even though both use dollars. However, the use of a common currency tends to keep prices of internationally traded goods close to the levels of the same goods in the U.S. Thus, while there are some differences in price levels, inflation rates in the two countries will tend to be similar.
One of the main differences for a country that is dollarized, such as Panama, is it does not have access to the Federal Reserve as a lender of last resort. The Fed is a lender of last resort only to U.S. banks. However, a country that is dollarized can borrow in world markets or from U.S. banks.
In addition to countries that are officially dollarized, many developing countries have a limited, unofficial form of dollarization. This means residents choose to hold foreign currency and foreign currency-denominated deposits at domestic banks.
In high-inflation countries, dollars may be used as frequently as the local currency in daily transactions. Informal dollarization is a response to economic instability and high inflation in one’s home country.
Pros and Cons of a Common Monetary Unit
Increased trade volume
Stabilized monetary policy for inflation-prone countries
Commitment to price control
Loss of independent monetary policy
Giving up seigniorage, or revenue from money production
- Increased volume of trade: Research has shown that sharing a common currency boosts trade between countries by a factor of two to three.
- Stabilized monetary policy for inflation-prone countries: Another advantage of a common monetary unit is a less-volatile monetary policy. Countries that overstimulate their economies and monetize their debts are helped with a more stable monetary policy. This is seen as a better alternative than fixing an exchange rate, as it is more costly to “turn back” to an old currency after adopting a different currency.
- Commitment to price control: Dollarization also is believed to be a pledge to help stimulate economic growth in the country adopting it.
- Loss of independent monetary policy: Dollarization necessitates the elimination of a freestanding monetary policy that can be used to stabilize the country’s economy during business cycles. Independent central banks, which have full control over their currency, can assist in making money more freely available in their countries during downturns to stimulate aggregate demand. This can lead to more potential swings in economic output and unemployment.
- Giving up seigniorage, or revenue from money production: Choosing to dollarize forfeits the profits associated with minting and issuing money.
- Dollarization refers to the adoption of another country’s currency as legal tender.
- Dollarization is commonly chosen by countries that have high inflation and want to stabilize their price levels and economies.
- Countries that are highly integrated with the U.S. in trade or financial relations may find it beneficial to dollarize.