Financial Markets and Institutions (2-downloads)

Dollarization

Dollarization, which involves the adoption of another

country’s currency, usually the U.S. dollar (but other

sound currencies like the euro or the yen are also

possibilities), is a more extreme version of a fixed

exchange rate than is a currency board. A currency

board can be abandoned, allowing a change in the

value of the currency, but a change of value is impos-

sible with dollarization: A dollar bill is always worth

one dollar whether it is held in the United States or

outside of it. Panama has been dollarized since the

inception of the country in the early twentieth century,

while El Salvador and Ecuador have recently

adopted dollarization.

Dollarization, like a currency board, prevents a

central bank from creating inflation. Another key

advantage is that it completely avoids the possibility

of a speculative attack on the domestic currency

(because there is none) that is still a danger even

under a currency board arrangement. However, like

a currency board, dollarization does not allow a

country to pursue its own monetary policy or have a

lender of last resort. Dollarization has one additional

disadvantage not characteristic of a currency board:

Because a country adopting dollarization no longer

has its own currency, it loses the revenue that a gov-

ernment receives by issuing money, which is called

seigniorage. Because governments (or their central

banks) do not have to pay interest on their currency,

they earn revenue (seigniorage) by using this cur-

rency to purchase income-earning assets such as

bonds. In the case of the Federal Reserve in the

United States, this revenue is usually in excess of 

$20 billion dollars per year. If an emerging-market

country dollarizes and give up its currency, it needs

to make up this loss of revenue somewhere, which is

not always easy for a poor country.

equals the foreign interest rate. Therefore, changes in the monetary policy in the large

anchor country that affect its interest rate are directly transmitted to interest rates

in the small country. Furthermore, because the monetary authorities in the small

country cannot make their interest rate deviate from that of the larger country, they

have no way to use monetary policy to affect their economy.

Smaller countries are often willing to tie their exchange rate to that of a larger

country in order to inherit the more disciplined monetary policy of their bigger neigh-

bor, thus ensuring a low inflation rate. An extreme example of such a strategy is

the currency board, in which the domestic currency is backed 100% by a foreign

currency (say dollars) and in which the note-issuing authority, whether the central

bank or the government, establishes a fixed exchange rate to this foreign currency

and stands ready to exchange domestic currency for the foreign currency at this rate

whenever the public requests it. Currency boards have been established in coun-

tries such as Hong Kong (1983), Argentina (1991), Estonia (1992), Lithuania (1994),

Bulgaria (1997), and Bosnia (1998). Argentina’s currency board, which operated from

1991 to 2002, is one of the most interesting and is described in the Global box,

“Argentina’s Currency Board.”) An even more extreme strategy is dollarization,

in which a country abandons its currency altogether and adopts that of another coun-

try, typically the U.S. dollar (see the Global box, “Dollarization”).

A serious shortcoming of fixed exchange rate systems such as the Bretton Woods

system or the European Monetary System is that they can lead to foreign exchange

crises involving a “speculative attack” on a currency—massive sales of a weak cur-

rency or purchases of a strong currency that cause a sharp change in the exchange

rate. In the following case, we use our model of exchange rate determination to

understand how the September 1992 exchange rate crisis that rocked the European

Monetary System came about.

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