| National currencies are tradable goods par excellence. They can be easily carried across borders, and some of them enjoy wide recognition around the world. There is thus a tendency for currencies that display high inflation to be replaced by currencies like US dollar that has earned a reputation for being relatively successful in maintaining its purchasing power over time. In fact ,currency substitution has influenced more and more developing countries' macroeconomy. This paper provides a selective review of the issues related to the phenomenon of "currency substitution," defined as the rapid erosion of the value of domestic currency leads agents to substitute it by foreign currency in either any or all of the basic functions of money. This phenomenon is also simply referred to as dollarisation. The phenomenon of currency substitution raises many interesting and difficult questions, both from policy and analytical perspectives.Our focus will be on policy and analytical issues that are relevant to developing countries. There are no clear-cut answers to most of these questions, which makes any discussion of currency substitution a rather demanding, but fascinating, endeavor. This paper discusses those issues that, in our judgment, are the most relevant for developing countries. The discussion proceeds as follows. In Section I ,we introduce the concept and the measure of currency substitution. A note on terminology is due. In this paper ,currency substitution is used to indicate that a foreign currency serves as a unit of account or as a store of value, and not necessarily as a medium of exchange.The effects of currency substitution on the economy of developing countries are discussed in Section II. First, we discuss the effects of currency substitution on the exchange rate. Standard models suggest that the higher the elasticity of substitution between the two currencies, thehigher the shift from domestic to foreign currency induced by a fall in expected inflation, and thus the higher the appreciation of the domestic currency. Hence, a sufficiently high elasticity of substitution is likely to make the exchange rate extremely volatile in response to policy changes and/or credibility problems. Second, The issue of monetary policy under currency substitution is reviewed . Since currency substitution complicates the money supply and demand ,it reduces the effectiveness of monetary policy and constrains policymakers' ability to implement economic policy. Finally,we analyze how currency substitution affects both the level and variability of the inflation tax and revenues from money creation.Currency substitution transfers the seigniorage income and could spur the improvement of inflationaru rate. Policy issue, analyzed in Section III, is whether currency substitution should be encouraged or not. Views about the optimal degree of currency substitution cover a very wide spectrum. They range from the idea that some countries should completely give up issuing their own money and adopt a foreign currency ("full dollarization" i.e., adopting a foreign currency as the only legal tender, as in Panama), to the notion that every effort should be made to induce the use of the domestic currency. This section discusses these two polar views. We argue that there does not seem to be a good case for discouraging the use of foreign currency. A second approach follows the optimal taxation literature and examines whether the presence of currency substitution makes it optimal to resort to the inflation tax. Such forced de-dollarizations often have opposite effects to those intended by the authorities. Instead, it seems to have stimulated the capital flight problem and simply driven the dollarized economy underground.On the other hand, the case for encouraging the use of foreign currency is also less than obvious, mainly due to the inflationary consequences of higher currency substitution. The extreme measure of fully dollarizing the economy may put unnecessary constraints on the economy and render the banking system more... |
PDF Full Text Request