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Dollarization is the tendency for countries to use the US Dollar (USD) or another foreign currency in local transactions. It can take place unofficially or officially, directly or indirectly. Pegging a local currency to a foreign one is a method of indirect dollarization. The advantages of dollarization are typically seen as stability of the local currency and a reduction of risk. The disadvantages include the inability to administer monetary policy and other controls over the local economy.
The incentive for dollarization is apparent in the case of a developing country. With a more stable currency, such countries are in a better position to attract foreign investment in their infrastructures and economies. Long-term investors are generally weary of unpredictable currencies. With larger risk, the chance of receiving no return on one’s investment is significant.
First of all, dollarization can occur unofficially. When a local currency tends to have high inflation or fluctuating value, people often prefer to use a more stable foreign currency. This can be seen in many border towns or regions in countries adjacent to a more developed country. Seeking the stability of the foreign currency, sellers of goods and services may accept or demand the foreign money for their transactions. Official policy may ignore the use of foreign currency, but if it is frequent enough, this is considered one form of dollarization.
Official dollarization can also occur. In this case, a country’s monetary authorities cease to produce local currency and adopt a foreign one. The countries of Panama, Ecuador, El Salvador and others have adopted the US Dollar in this way. Official dollarization is perhaps the most direct way of reducing monetary risk in a country. On the other hand, it causes a country to lose out on the benefits of monetary policy. Monetary policy is a tool available to governments to manipulate interest and inflation rates, which in turn affects overall economic activity.
One type of indirect dollarization is to peg a local currency to a foreign one. Pegging is essentially “anchoring” the value of local currency to that of a foreign one by locking in a fixed exchange rate. In this way, local currency notes are still used, but their value will remain tied to a foreign currency. The currencies of both Saudi Arabia and Cuba have recently been pegged to the US Dollar, while the currencies of many West African countries have been pegged to the euro.
If you visit Central America it is a good idea to get used to the dollarization discipline. Many countries have long adopted the idea that holding USD is the way to stay safe when their country has economic issues.
Take the dollarization in El Salvador for example, they actually switched officially to the greenback to have a more stable economy and a secure place in the world market. Panama is another example of a large nation that now officially uses USD.
I am actually not sure if I am totally for dollarization as it seems that a nation taking on another nation's currency lose a piece of their identity. What do you think about the dollarization going on in the world?
When I was traveling in Cambodia it was really common for the locals to demand the American dollar, as there was a well known floating exchange rate that kept transactions pretty fair. I actually remember going into a few shops and restaurants there that refused to take their own country's currency.
I think that when a country's currency gets to the point where the locals don't even want to deal with it, that it is not a bad idea to promote financial dollarization. I really can't blame the people there for wanting USD when their own exchange rate was so volatile. I can't imagine what it would be like not knowing whether or not your money would be worth anything from one day to the next.
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