Dollarization occurs when a country either formally or informally uses another country's currency rather than its domestic currency as the primary medium of exchange. Informally, individual businesses or citizens may transact business in another currency; formally, countries may "peg" their currencies to another, such as Ecuador has done. The term "dollarization" is used because the US dollar is frequently the currency used by the other nation. This research considers some of the effects of dollarization by examining recent literature on the topic.
Dollarization ostensibly is undertaken by a government in consultation with a central bank, but there is strong evidence that dollarization occurs at a much more informal basis long before the official move is made. Sometimes called de facto dollarization, this occurs when individual businesses and investors begin to transact business in dollars in order to take advantage of the stability of the dollar relative to the volatile local currency (Feige et al 3).
Unofficial dollarization has long-term consequences for the country where it is practiced. As increasing numbers of dollars flow into and out of the country, the nation's own economic strategies are likely to lose their effectiveness since dollars comprise an increasingly large share of the economy. This can be perplexing for policy makers who might be seeking to maintain a specific inflation target or otherwise lessen the risk to investors. At the same time, increased unofficial dollarization makes it easier for companies and individuals to "hide" transactions and evade tax liabilities. Perhaps mord detrimental for nations, dollars often become part of an underground economy in which the currency is kept out of official channels and the economy moves beyond the ability of the government's ability to manage the currency effectively (Feige et al 5).
One of the biggest problems associated with the de facto dollarization of...