Common Currency: Pros and Cons of Dollarization

1
Common CurrencyPros and Cons of Dollarization

• Examples of Dollarized Countries
• Ecuador (since 2000), El Salvador (since 2001),
  and Panama (since 1904)

2
General economic arguments for dollarization

• Dollarization practically eliminates the
  likelihood of currency crises and provides
  greater currency stability for the adopting
  country. Without a domestic currency, there is
  no risk of a sharp devaluation or of sudden
  capital outflows driven by fears of devaluation.
  This allows the dollarized country to reduce the
  risk premium and thus interest rates paid on
  foreign debt, thereby lowering the borrowing
  costs for both the government and the private
  sector. Lower interest rates would boost
  business investment and enhance economic growth.
• Since dollarization minimizes currency exchange
  risks and reduces transaction costs for
  cross-border trade and investment activities, it
  would enhance trade ties with the U.S. and
  attract foreign investment from the U.S. and
  other countries as well. Dollarization would
  thus increase the integration of the dollarized
  economy with both the U.S. and the global economy.

3
General economic arguments against dollarization

• The dollarized country would lose control over
  monetary policy as a tool to deal with domestic
  economic problems. Specifically, the country
  would not be able to conduct its own monetary
  policy to bolster growth or combat inflation when
  needed. Adopting the dollar means that the U.S.
  central bank would set interest rates. Since the
  U.S. might have different economic conditions and
  different domestic objectives, the U.S. monetary
  policy could be at odds with the needs of the
  dollarized economy.
• Dollarization would remove the adopting countrys
  ability to use exchange rate adjustment to meet
  domestic economic objectives. If its economy
  gets worse, the dollarized country would not be
  able to boost the economy by devaluing its
  currency to promote exports.
• If other currencies depreciate substantially
  relative to the dollar, it would hurt the
  competitiveness of the dollarized countrys
  exports seriously. Of course, if other
  currencies appreciate considerably against the
  dollar, it would be a boom to the exports from
  dollarized country.

4
A political argument against dollarization

• Politically, a country is often reluctant to
  abandon its own currency, a symbol of its
  national pride and sovereignty. As a result,
  political resistance is nearly certain and likely
  to be very strong.