Dollarization Essay ⋆ Business Essay Examples ⋆ EssayEmpire

Official dollarization refers to the practice by some countries of using the U.S. dollar as their official currency. In such a system, there is no central bank, no independent monetary policy, and no independent exchange rate. By adopting the U.S. dollar, a country enjoys price stability because the job of currency production is implicitly outsourced to the United States. Moreover, the practice makes it possible for international commerce and trade to be conducted with fewer currencies.

Unofficial dollarization involves the unofficial use of a foreign currency, usually the U.S. dollar, by the residents of a country while the domestic currency still circulates alongside the foreign currency. Unofficial dollarization includes cases where holding foreign assets is legal as well as illegal. The motivation for holding foreign assets by residents is to hedge against spiraling inflation.

Proponents of dollarization argue that there are too many currencies circulating in the world today and that this can become dangerous and inefficient. All of these currencies are backed by the confidence that investors have in them. When there is too much pressure on these currencies, the monetary authorities yield to devaluation. Devaluation brings hardship to the people as a result of attendant inflation. On the other hand, dollarization results in low inflation and relatively stable interest rates.

When the focus is on the individual as a decision maker, an economic choice becomes logical. Economists argue in favor of “consumers’ sovereignty” rather than a national monetary sovereignty. The question then becomes: Who should possess the power to choose what currency to use? Proponents of dollarization argue that the choice should reside with individual consumers.

The recent financial crisis in several developing countries of the world (for example, the Asian financial crisis) is an indicator of the failure of monetary management in these countries. The failure of the Argentinean currency board system is a case in point. These crises can be avoided if dollarization is adopted because the national government is removed as an issuer of currency. In most countries of the world, the central banks have performed poorly in terms of promoting low inflation, foreign exchange management, and general monetary stability.

Dollarization is not a mechanism for replacing the monopoly of a domestic monetary institution with a monopoly of a foreign monetary authority. Some scholars argue that it is an evolutionary process for selecting an appropriate currency in terms of economic strength. It gives a country the opportunity to examine several currencies from which it could abandon an inferior one for a strong one.

Another legitimate argument in favor of dollarization is based on the concept of impossible trinity. This concept is the foundation of macroeconomics of open economy. It is premised on the idea that a country cannot achieve a fixed exchange rate, free movement of capital, and an independent monetary policy at the same time. At best, a country can achieve two. A country that pursues dollarization can overcome exchange rate volatility relative to the U.S. dollar and, consequently, can avoid future currency crisis. Moreover, such a country will benefit from an increased economic integration with the U.S. economy.

There are several key arguments against dollarization. The currency of a nation is a source of national pride and sovereignty that should not be transferred to another entity. The second argument is premised on the role of a central bank in an economy. In a dollarized economy, a central bank cannot create money. Therefore, it cannot serve as a lender of last resort. Critics of dollarization argue that the banking system in any country needs a lender of last resort to guard against panics. It is also important to have a central bank with power over monetary policy. This is because a central bank is the only institution that can restrain politicians through monetary policy instruments by neutralizing negative consequences of fiscal policy.

With dollarization, a country loses the benefit of seignorage. It is a gain associated with issuing money in an economy. For example, issuing new money may reduce the value of old money as a result of inflation and consequently reduce the liability associated with old money, thus creating implicit benefits for a money-issuing government. Finally, critics argue that Panama’s economic prospects, for example, have not been outstanding even though it dollarized in the early 1900s. Other nations that recently adopted dollarization include El Salvador, Ecuador, and East Timor.

Bibliography:

Bekaert and R. J. Hodrick, International Financial Management (Pearson Prentice Hall, 2008);
James W. Dean and Thomas D. Willett. The Dollarization Debate (Oxford University Press, 2003);
Jeffrey J. Fox and Richard Gregory, The Dollarization Discipline: How Smart Companies Create Customer Value … and Profit from It (Wiley, 2004);
Gross, “The Case For Fewer But Stronger Currencies,” New York Times (2006);
Livingston, Money and Capital Markets (Kolb, 1993);
Melvin, International Money & Finance (Pearson Addison-Wesley, 2004);
Moffett, A. Stonehill, and D. Eiteman, Fundamentals of Multinational Finance (Pearson Prentice Hall, 2008);
J. O’Brien, International Financial Economics (Oxford, 2005);
Elizabeth Spiers, “The World’s Worst Inflation,” Fortune (v.158/3, 2008);

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