Dollarization, euroization

Dollarization refers to the case when a country decides to abandon its own currency and to substitute it with a foreign currency. As the foreign currency is usually the dollar, the policy has been termed "dollarization." However, the country may adopt the euro or another foreign currency as its own. Official dollarization should be distinguished from unofficial dollarization where replacing the domestic currency with a foreign currency is not official policy. Instead, the people and the companies prefer to use, say, the dollar or the euro instead of their own currency.

Pros: Dollarization, both official and unofficial, occurs usually in countries with a history of high inflation and exchange rate volatility. It reflects the loss of trust in the domestic currency. The authorities prefer to adopt the stable currency of another country to ensure low inflation and to remove exchange rate uncertainty with respect to the dollar (or the euro). Observe on the chart the decline of the inflation rate of Ecuador after it started using the dollar as official currency in 2000.

Besides low inflation, dollarization is also expected to stimulate international trade and investment as it removes currency risks. Firms are more likely to engage in international transactions if they don't worry about the changes to exchange rates.

Cons: Dollarization means that the country loses monetary policy altogether. It cannot expand or contract money supply to respond stimulate or slow down the economy. Therefore, the country may experience deeper recessions. The option to depreciate the currency and try to stimulate exports is also eliminated since the entire economy operates with dollars.

For those reasons, very few countries have actually dollarized their economies. Most governments prefer to keep open their policy options and to have flexibility when they need it. As of 2017, these are some of the countries where the dollar is the official currency:

- Ecuador
- El Salvador
- Panama

These are all relatively small economies that are open to international trade and investment.


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