Dollarization: How Foreign Currency Becomes Part of an Economy

Dollarization is the use of a foreign currency by residents of a country, either alongside or instead of the domestic currency. The term can describe currencies other than the U.S. dollar. The key question is not simply whether foreign notes appear in an economy, but how extensively the foreign currency is used and what legal status it has.

Official dollarization occurs when a jurisdiction adopts another jurisdiction’s currency as legal tender and does not maintain an independent national currency issuance system as its primary monetary arrangement. In practice, a limited ability to issue fractional coins can coexist with official dollarization, so the definition should not be read as requiring that every coin used in the country be produced abroad. Ecuador illustrates this qualification: the U.S. dollar replaced the sucre as legal tender, while the Central Bank of Ecuador retained authority to issue fractional coins.

De facto or informal dollarization is different. The domestic currency remains in place, but residents use foreign currency for some payments, savings, borrowing, or pricing. Informal dollarization can therefore exist without a formal legal-tender replacement.

Dollarization can be grouped into three forms:

1. Transaction dollarization: a foreign currency is used for domestic payments. 2. Financial dollarization: foreign-currency assets or liabilities are used, such as savings or borrowing denominated in a foreign currency. 3. Real dollarization: domestic prices, wages, or other transactions become linked or indexed to the exchange rate.

These forms can overlap. For example, a foreign currency may first become attractive as a way to preserve savings, then become more common in payments and pricing.

1. Define dollarization and distinguish official dollarization from informal use of a foreign currency alongside domestic money.

2. Why might households prefer a foreign currency after a history of high domestic inflation or exchange-rate instability?

3. Explain one potential benefit of dollarization for price stability or transaction confidence and one policy cost.

4. What monetary-policy tool becomes more constrained when a country gives up its own currency?

5. Compare currency substitution for savings with use of foreign currency for everyday pricing and payments.

6. Correct this statement: “Dollarization means the United States controls every economic policy of the dollarized country.”