What Is Dollarization?
Dollarization is when the U.S. dollar is used in addition to or instead of the domestic currency of another country. It is an example of currency substitution. Dollarization usually happens when a country’s currency loses its usefulness as a medium of exchange due to hyperinflation or instability.
KEY TAKEAWAYS
- Dollarization is when a country begins recognizing the U.S. dollar as a medium of exchange or legal tender alongside or in place of its domestic currency.
- Dollarization typically occurs when the local currency has become unstable and begun to lose its usefulness as a medium of exchange for market transactions.
- Dollarization can have both benefits and costs. It typically results in enhanced monetary and economic stability but necessarily involves a loss of financial autonomy in monetary policy.
Understanding Dollarization
Dollarization usually occurs in developing countries with weak central monetary authority or unstable economic environments. It can occur as an official monetary policy or a de facto market process. Either through official decree or adoption by market participants, the U.S. dollar comes to be recognized as a generally accepted medium of exchange for use in day-to-day transactions in a country’s economy. Sometimes the dollar assumes official status as legal tender in the country.
The main reason for dollarization is to receive the benefits of more excellent stability in the value of currency over a country’s domestic currency. For example, the citizens of a country in an economy undergoing rampant inflation may choose to use the U.S. dollar to conduct day-to-day transactions since inflation will cause their domestic currency to have reduced buying power.
Another aspect of dollarization is that the country gives up some of its ability to influence its economy through monetary policy by adjusting its money supply. The dollarizing government effectively outsources its monetary policy to the U.S. Federal Reserve. This can be a negative factor to the extent that U.S. period monetary policy is set in the interest of the U.S. economy and not the interests of dollarized countries.
However, it can be beneficial if it helps takes advantage of an economy of scale in monetary policy that allows the dollarizing country to economize on resources that would need to be devoted to supplying and managing its money supply. It may also be the case that domestic authorities have proven themselves incompetent in managing their monetary policy. Giving up an independent monetary policy can move the dollarizing country closer to an optimal currency area with the dollar. Small countries that engage in a relatively large volume of trade with and have strong economic ties to the U.S. will significantly benefit.
An Example of Dollarization
Zimbabwe ran a dollarization test to see if adopting foreign currency could stave off high inflation and stabilize its economy. Zimbabwe dollar inflation reached an estimated rate of 2.2 million percent in July 2008. The acting finance minister announced that the U.S. dollar would be accepted as legal tender for several merchandisers and retailers. After the experiment, the finance minister announced that the country would adopt the U.S. dollar by legalizing its general use in 2009 and later suspending the Zimbabwe dollar in 2015.
Dollarization in Zimbabwe immediately worked to reduce inflation. This reduced the instability of the country’s overall economy, allowing it to increase its citizens’ buying power and realize increased economic growth. Additionally, long-term financial planning became easier for the country since the stable dollar attracted foreign investment.
However, dollarization wasn’t a smooth ride for the country and had drawbacks. All monetary policy would be created and implemented by the United States, some thousands of miles away from Zimbabwe. Decisions made by the Federal Reserve do not consider Zimbabwe’s best interests when creating and enacting policy. The country had to hope that any decisions, such as open market operations, would be beneficial. Not only could Zimbabwe not make its goods and services cheaper in the world market by devaluing its currency but the effect dollarization had on banking regulations discouraged foreign investments from other countries.
In 2019, Zimbabwe reversed course by reintroducing a new Zimbabwe dollar known as the Real Time Gross Settlement dollar in February and outlawing the use of the U.S. dollar and other foreign currencies in June. Inflation in the new Zimbabwe dollars has been steep, and substantial use of the U.S. dollar as a black market currency persists.10 Despite the challenges, as of 2022, Zimbabwe has stated that they have no intention of returning to dollarization.
