Dollarisation is the act of substituting a foreign currency for a domestic currency in order to fulfil the essential functions of money as a medium of exchange (currency substitution) or as a store of value (asset substitution). In practice, dollarization occurs when a nation de jure adopts the currency of a foreign country to completely replace its domestic currency. Hence, the foreign currency serves as a transaction medium, a store of value, and a unit of account. Firms and individuals who, in the absence of such sanctions, substitute a foreign currency for the domestic currency as a means of payment (currency substitution) and/or choose to hold foreign rather than domestic denominated monetary assets (asset substitution) are commonly referred to as unofficial, spontaneous, or de facto dollarization.
Over the most recent couple of many years, the term dollarization has been utilized to determine various peculiarities. Subsequently, it is pivotal to reveal some insight into the befuddling terminology. In general, dollarization can be characterized as “the holding by occupants of a huge portion of their assets as foreign currency‐denominated assets” (BALINO et.al 1999:1). Besides, there is between official (de jure) and unofficial (de facto) dollarization.
For a time of over twenty years, the term dollarization is related with the way that domestic inhabitants of a particular nation hold foreign currency cash or foreign‐denominated assets as a feature of their resource portfolio. Toward the end of the 1990s, notwithstanding, the discussion starts to focus progressively on the issue of full (de jure) dollarization. This type of dollarization happens when a country assumes an abstinence from issuing its domestic currency and embraces a foreign alternative, more steady currency as the country’s official legal tender. Usually, this U.S. dollar is this foreign currency for the purpose. De-jure dollarization centres fundamentally around the policy issue of choosing an optimal exchange rate regime for developing or emerging market economies.
The involuntary form and idea of partial (de facto) dollarization occurred when authorities preserve national money as the official legal tender for the country, while residents decide to utilize one or a few foreign currencies alongside domestic one. Consequently, a bi‐currency framework successfully takes hold of the economy.
De facto dollarisation is commonly the rational reaction of economic agents to a lack of confidence within home currency, frequently ensuing from episodes of inflation, currency devaluations and/or currency confiscations. It will also be associated with the increase of underground or ‘unrecorded’ economic activities given that currency, especially foreign currency, is regularly the preferred medium of exchange for such transactions. De facto dollarisation results in a lack of seigniorage, thwarts the economic authority from pursuing inflationary finance and inhibits its effectiveness in controlling exchange rates. It also minimises the costs of tax evasion, limiting the fiscal authority’s capacity to command real resources from the private sector. De facto dollarisation, by encouraging underground operations, can lead to a distortion in many macroeconomic activity metrics, making macroeconomic policy formulation more complex. However, since de facto dollarisation reveals a hidden preference for holding foreign currency to mitigate the risks of domestic inflation and exchange rate depreciation, it has a number of positive consequences, including increased portfolio efficiency and fewer incentives for inflationary finance and capital flight. The dollarisation literature is rife with normative discussions about the appropriateness of legal dollarisation, but when seeking to analyse positive topics such as the causes, effects, costs and benefits of currency, and asset substitution, it has suffered from a fundamental empirical problem. This ‘fundamental difficulty,’ according to Calvo and Vegh (1992), is caused by the fact that “there are usually no data available on currency circulating in an economy,” and so “the importance of currency substitution” is “essentially unobservable.”
The outcomes of informal dollarization are complex. As a general rule, two significant gatherings of financial approach concerns can be recognized. From one viewpoint, there is the broadly held view that dollarization makes money related and conversion scale strategy less compelling and transmission more mind boggling. Then again, there are those worries that allude to the dangers for macroeconomic and monetary dependability. As the past area has shown, a definitive objective of money related strategy is social government assistance. Along these lines, money related arrangement ought to be similarly worried about the two gatherings.
Customarily, policymakers will generally be dominatingly worried about the way that dollarization blocks the viability of money related approach. This ordinary view depends especially on early money replacement models and the perception that dollarized nations were frequently portrayed by altogether higher expansion than non‐dollarized economies.
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