What Is Dollarization?

Dollarization is the term for when the U.S. dollar is used in addition to or instead of the domestic currency of another country. It is an example of currency substitution. Dollarization usually happens when a country’s own currency loses its usefulness as a medium of exchange, due to hyperinflation or instability.

Key Takeaways

  • Dollarization is when a country begins to recognize the U.S. dollar as a medium of exchange or legal tender alongside or in place of its domestic currency.
  • Dollarization normally occurs when the local currency has become unstable and begun to lose its usefulness as a medium of exchange for market transactions.
  • Dollarization can have both benefits and costs. It typically results in enhanced monetary and economic stability, but necessarily involves loss of economic autonomy in monetary policy.

Understanding Dollarization

Dollarization usually occurs in developing countries with a weak central monetary authority or an unstable economic environment. It can occur as an official monetary policy or as a de facto market process. Either through official decree or through adoption by market participants, the U.S. dollar comes to be recognized as a generally accepted medium of exchange for use in day-to-day transactions in a country’s economy. Sometimes the dollar assumes official status as legal tender in the country.

The main reason for dollarization is to receive the benefits of greater stability in the value of currency over a country's domestic currency. For example, the citizens of a country within an economy that is undergoing rampant inflation may choose to use the U.S. dollar to conduct day-to-day transactions, since inflation will cause their domestic currency to have reduced buying power

Another aspect of dollarization is that the country gives up some of its ability to influence its own economy through monetary policy by adjusting its money supply. The dollarizing country effectively outsources their monetary policy to the U.S. Federal Reserve. This can be a negative factor, to the extent that U.S. period monetary policy is set in the interest of the U.S. economy and not the interests of dollarized countries.

However, it can be beneficial if it helps takes advantage of an economy of scale in monetary policy that allows the dollarizing country to economize on resources that would need to be devoted to supplying and managing its own money supply. It may also be the case that domestic authorities have proven themselves incompetent to manage their own monetary policy. Giving up an independent monetary policy can move the dollarizing country closer to an optimal currency area with the dollar. Small countries that engage in a relatively large volume of trade with and have strong economic ties to the U.S. will especially benefit.

An Example of Dollarization

Zimbabwe ran a dollarization test to see if the adoption of foreign currency could stave off high inflation and stabilize its economy. Zimbabwe dollar inflation reached estimated annual rate of 250 million percent in July 2008. Zimbabwe's currency had become so worthless that it was widely being used as insulation and stuffing in furniture, and many Zimbabweans had begun either to adopt foreign currencies for transacting business or resorting to simple barter. The acting finance minister announced that the U.S. dollar would be accepted as legal tender for a select number of merchandisers and retailers. After the experiment, the finance minister announced that the country would adopt the U.S. dollar, by legalizing its general use in 2009 and later suspending use of the Zimbabwe dollar in 2015.

Dollarization in Zimbabwe immediately worked to reduce inflation. This reduced the instability of the country's overall economy, allowing it to increase its citizens' buying power and realize increased economic growth. Additionally, long-term economic planning became easier for the country, since the stable dollar attracted some foreign investment.

However, dollarization wasn't an entirely smooth ride for the country, and there were drawbacks. All monetary policy would be created and implemented by the United States, some thousands of miles away from Zimbabwe. Decisions made by the Federal Reserve do not take into account the best interests of Zimbabwe when creating and enacting policy, and the country had to hope that any decisions, such as open market operations, would be beneficial. Further, Zimbabwe became disadvantaged when trading with local partners, such as with Zambia or South Africa. Zimbabwe could not make its goods and services cheaper in the world market by devaluing its currency, which would attract more foreign investments from these countries.

In 2019, Zimbabwe reversed course by reintroducing a new Zimbabwe dollar known as the Real Time Gross Settlement dollar in February and outlawing the use of the U.S. dollar and other foreign currencies in June. Inflation in the new Zimbabwe dollars has been steep, and substantial use of the U.S. dollar as a black market currency persists.