What Is Dollarization?
Dollarization occurs when the U.S. dollar is used in addition to or instead of the domestic currency of another country. It is a form of currency substitution that typically takes place when a country’s own currency suffers severely from hyperinflation or financial instability.
Key Takeaways
- Dollarization involves the recognition and use of the U.S. dollar alongside or in place of a country’s domestic currency.
- It generally happens due to the instability of the local currency, impacting its value and usefulness for transactions.
- Dollarization offers both stability and challenges—enhancing economic stability but sacrificing control over national monetary policy.
Understanding Dollarization
In many cases, dollarization arises in nations with fragile central banking systems or unstable economic frameworks. Dollarization can manifest through formal governmental policy or naturally through market adoption. Whether by official decree or through widespread market usage, the U.S. dollar becomes a key medium of exchange within the economy. It sometimes even attains the status of legal tender.
The primary driving factor behind dollarization is gaining monetary stability greater than that which the national currency can provide. For instance, residents of a country battling skyrocketing inflation may prefer using the U.S. dollar for daily transactions, as relentless inflation erodes their currency’s buying power.
A downside to dollarization is the partial forfeiture of national economic control. Monetary policy management effectively transfers to the U.S. Federal Reserve, whose policies align with U.S. interests, not necessarily those of the dollarizing country. This divergence can sometimes lead to adverse effects on the dollarizing nation’s economy.
On the flip side, dollarization can help streamline economic resources by leveraging the U.S. monetary policy framework, thus potentially fostering an optimal currency zone with the dollar. Small economies with significant trade with the U.S. are likely to see considerable benefits.
An Example of Dollarization
Let’s exemplify dollarization through Zimbabwe’s monetary experiment. Facing an inflation rate peaking at an estimated 2.2 million percent in July 2008, Zimbabwe initiated a trial accepting the U.S. dollar as legal tender for specific merchants and retailers. By 2009, Zimbabwe fully endorsed the U.S. dollar, suspending the national currency by 2015.
Dollarization quickly mitigated Zimbabwe’s inflation, yielding greater economic stability. Citizens regained buying power, and the nation experienced enhanced long-term economic planning, spurred by the stability of the U.S dollar which attracted some foreign investments.
Despite these advantages, drawbacks existed, as Zimbabwe relinquished its autonomous monetary policy to the U.S. Ambiguities arose when Federal Reserve policies misaligned with Zimbabwe’s economic interests. Moreover, Zimbabwe found itself unable to devalue its currency to make exports competitively priced on the global market. Stringent banking regulations also stifled the inflow of some foreign investments.
In a reverse move by 2019, Zimbabwe reintroduced the Zimbabwe dollar and banned the U.S. dollar and other foreign currencies—this phase is known as de-dollarization. While the new Zimbabwe dollar suffers substantial inflation and continued black market reliance on the U.S. dollar, Zimbabwe as of 2022, maintains resoluteness against returning to dollarization.
Related Terms: Currency Substitution, Legal Tender, Monetary Policy, Optimal Currency Area, Economies of Scale.
References
- Federal Reserve Bank of Atlanta. “Costs and Benefits of Dollarization”, Page 4.
- Federal Reserve Bank of Atlanta. “Costs and Benefits of Dollarization”, Pages 4-5.
- Federal Reserve Bank of Atlanta. “Costs and Benefits of Dollarization”, Pages 7-8.
- Federal Reserve Bank of Atlanta. “Costs and Benefits of Dollarization”, Pages 8-9.
- The New York Times. “Zimbabwe Pegs Inflation at 2.2 Million Percent”.
- Global Financial Data. “The Death of the Zimbabwe Dollar”.
- Cato Institute. “Dollarization: The Case of Zimbabwe”, Pages 348-349.
- Cato Institute. “Dollarization: The Case of Zimbabwe”, Page 349.
- Cato Institute. “Dollarization: The Case of Zimbabwe”, Pages 358-360.
- U.S. Department of State. “2019 Investment Climate Statements: Zimbabwe”.
- Bloomberg. “Zimbabwe’s Central Bank Rules Out Return to Dollarization”.
