The term “dollarization” is also shorthand for the use of any foreign currency by another country. An example of a country that has adopted the U.S. dollar as legal tender is Panama. It dollarized in 1904, although a national currency, the balboa, is used for small transactions. Panama’s decision to use the dollar as its official currency was based on strong political and economic ties to the U.S. Also, Panama has a unique location on a narrow strip of land between North and South America, which is a key trade route. Two other Central American countries, Ecuador and El Salvador, have dollarized economies as well. Dollarization contributes to greater economic integration due to low transaction costs during trade, because neither country needs to convert currency to buy goods. If the country adopts the U.S. dollar, or another widely accepted currency, it makes trade between the two countries—and sometimes others—quicker and cheaper.
How Does Dollarization Work?
Dollarization occurs when one country officially makes another country’s currency its legal tender. In an officially dollarized economy, the money supply works similar to that of the U.S. However, prices and money supply are determined by local preferences, and inflation rates can differ between the dollarized economy and the U.S. For example, Panama and the U.S., while both using the U.S. currency, can have different inflation rates, similar to the way that Dallas and New York City can have differing rates of inflation even though both use dollars. However, the use of a common currency tends to keep prices of internationally traded goods close to the levels of the same goods in the U.S. Thus, while there are some differences in price levels, inflation rates in the two countries will tend to be similar. One of the main differences for a country that is dollarized, such as Panama, is it does not have access to the Federal Reserve as a lender of last resort. The Fed is a lender of last resort only to U.S. banks. However, a country that is dollarized can borrow in world markets or from U.S. banks. In high-inflation countries, dollars may be used as frequently as the local currency in daily transactions. Informal dollarization is a response to economic instability and high inflation in one’s home country.
Pros and Cons of a Common Monetary Unit
Pros Explained
Increased volume of trade: Research has shown that sharing a common currency boosts trade between countries by a factor of two to three. Stabilized monetary policy for inflation-prone countries: Another advantage of a common monetary unit is a less-volatile monetary policy. Countries that overstimulate their economies and monetize their debts are helped with a more stable monetary policy. This is seen as a better alternative than fixing an exchange rate, as it is more costly to “turn back” to an old currency after adopting a different currency. Commitment to price control: Dollarization also is believed to be a pledge to help stimulate economic growth in the country adopting it.
Cons Explained
Loss of independent monetary policy: Dollarization necessitates the elimination of a freestanding monetary policy that can be used to stabilize the country’s economy during business cycles. Independent central banks, which have full control over their currency, can assist in making money more freely available in their countries during downturns to stimulate aggregate demand. This can lead to more potential swings in economic output and unemployment.Giving up seigniorage, or revenue from money production: Choosing to dollarize forfeits the profits associated with minting and issuing money.
