Dollarization as a Monetary Arrangement for Emerging Market Economies

Ecuador and El Salvador have recently adopted the U.S. dollar as legal tender, replacing their own national currencies.1 This same move has received serious attention in policy debates in both Argentina and Mexico. Abandoning the national currency is a decision with far-reaching economic and political implications that are not well understood. In response to this phenomenon, a growing literature has aimed at evaluating the economic costs and benefits of “dollarizing.” In this article, we provide an overview of the emerging literature and point out some issues that we feel warrant further research.2 Throughout, we focus on official dollarization, where the U.S. dollar (or some other currency) replaces the national currency as legal tender. Unofficial dollarization, where private agents use a foreign currency as a substitute for the domestic currency, is already widespread in Latin America and elsewhere. We focus on Latin America and the U.S. dollar because of the recent events and policy debates mentioned above. Most of the issues we discuss, however, would apply to any country considering the official adoption of a foreign currency. Discussions of the optimal monetary and exchange rate arrangements for an emerging market economy have traditionally centered on fixed or flexible exchange rates or (most often) some hybrid of the two, perhaps combined with capital controls or other regulatory measures. We begin our discussion by examining the causes of the current surge of interest in official dollarization. We then turn to the details of the issues that we feel are most important in analyzing the potential costs and benefits of dollarizing.