Dollarization is the term for when a foreign currency is used in addition to or instead of the domestic currency as legal tender. This process can also be called currency substitution.
Breaking Down Dollarization
Dollarization usually occurs in developing countries with a weak central government or an unstable economic environment. For example, the citizens of a country within an economy that is undergoing rampant inflation may choose to use a historically stable currency, like the U.S. dollar, to conduct day-to-day transactions, since inflation will cause their domestic currency to have reduced buying power. Dollarization does not always involve the U.S. dollar as the adopted foreign currency. The euro has also been adopted by non-EU members as its domestic currency.
Dollarization can be full or partial. Full dollarization takes place after a major economic crisis, as in the cases of Ecuador, El Salvador and Zimbabwe. In the case of partial dollarization, where a certain portion of the country's assets can be held in a foreign currency. It can also be done over time or a gradual currency conversion to full currency conversion.
Why Implement Dollarization?
The main reason for dollarization is to receive the benefits of greater stability in the value of a foreign currency over a country's domestic currency. The downside of dollarization is that the country gives up its ability to influence its own monetary policy by adjusting its money supply.
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. In 2008, the acting finance minister announced that Zimbabwe would run an 18-month experiment in which 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 completely, suspending use of the Zimbabwe dollar.
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.