1. ECON3315 International Economic Issues
Instructor: Patrick M. Crowley
Issue 16: Dollarization and Currency Boards

2. Overview Dollarization vs euroization
Costs and benefits of giving up the monetary unit
Optimum currency area theory
OCA in practice
Currency boards
The politics of exchange rates

3. Dollarization vs euroization
Defn: monetary authority = who issues the monetary base
Defn: monetary base = currency and reserves (what is used for making payments)
Defn: monetary standard = value of whatever is used as the medium of exchange and unit of account
Defn: convertibility = ability to convert monetary base into another currency
Dollarization is where a country replaces its own monetary base with the US dollar – therefore no monetary authority required.
Same idea works with euroization, although most countries adopting the euro are already in the European Union.

4. Costs and benefits of dollar/euroization
Costs of dollarizing:
- giving up control over exchange rate (and difficult to reverse)
- loss of seigniorage
- asymmetric shocks
Benefits of dollarizing:
- monetary policy credibility and economic stability
- increased trade
- no capital controls required

5. Optimum currency area theory
OCA came from famous paper by Robert Mundell (Canadian) in 1963
Main idea was that if countries had similar business cycles then single currency appropriate
If business cycles not that similar, still possible as long as
i) labor mobility, and/or
ii) capital mobility and/or
iii) fiscal redistribution (“coinsurance” or “equalization payments”)
Mundell looked to existing federations and noted that most of them had one or more of the above

6. Benefits of joining a MU

7. Costs of joining a MU

8. Costs vs benefits

9. OCAs in practice
Dollarized zones differ from monetary unions as in case of euro area all countries have a say in euro area monetary policy, whereas dollarized/euroized countries do not.
In practice monetary policy has to be suitable for business cycles or there has to be i) high level of trade or ii) high level of labor mobility
Easy to show theory but very difficult to implement OCA theory in practice

10. Currency boards
Currency board idea is to get all gains from using another country’s currency, without risk of devaluation and keeping option to reverse to legacy currency
Limited success in practice if government not already credible
Problems can arise from issuance of currency by other levels of government (e.g. Argentina)

11. Politics of exchange rates
Exchange rate is important economic policy lever the more open economy is
For most developing/transition countries a political trade off between policy autonomy (more flexible exchange rates) and attracting more policy credibility
Most countries resort to dollarization or currency boards after a bout of severe inflation or loss of confidence in government policies for other reasons