Dollarization

Dollarization occurs when the population of a country uses foreign currency instead of the domestic currency. The term is not only applied to usage of the United States dollar, but generally to the use of any foreign currency as the national currency. Countries have been desperately seeking ways to promote global economic stability and hence their own prosperity. For the majority of these countries, the optimal way to obtain currency stability has been to peg the local currency to a major convertible currency or another option is to abandon the local currency in favor of the exclusive use of the U.S. dollar (or another major international currency).

As an alternative to maintaining a floating currency or a peg, a country may decide to use full dollarization. The main reason a country would do this is to reduce its country risk, thereby providing a stable and secure economic and investment climate. Countries seeking full dollarization tend to be developing or transitional economies, particularly those with high inflation. Many of the economies opting for dollarization already informally use foreign tender in private and public transactions, contracts, and bank accounts; however, this use is not yet official policy, and the local currency is still considered the primary currency. The low risk encourages both local and foreign investors to invest money into the country and the capital market and the fact that an exchange rate differential is no longer an issue helps reduce interest rates on foreign borrowing.

There are some disadvantages to adopting a foreign currency. When a country gives up the option to print its own money, it loses its ability to directly influence its economy, including its right to administer monetary policy and any form of exchange rate regime. The central bank loses its ability to collect seigniorage, the profit gained from issuing coinage. Instead, the U.S. Federal Reserve collects the seigniorage, and the local government and gross...