Question

What is dollarization, and what is a currency board?

Answer 1

Before we get into the terms like Dollarization or Currency Board, let's understand the concept behind them.

Consider an economy which

1. Doesn't have a central bank or has a central bank but with very limited regulatory control and powers or
2. Has a political system that resorts to printing currency every now and then even when economy doesn't require it.

What will happen in this situation?

The economy will face:

1. Hyperinflation
2. Monetary destability
3. Local currency will lose value because it's inflated.
4. Residents, traders, investors etc will then start using some foreign currency to store value because local currency is hyperinflated and doesn't store any value for them.

Let's now look into each of the terms.

What is dollarization?

Dollarization is this phenomena where the citizens of a country start using foreign currency extensively either along with or in lieu of the local currency. Since USD is the most popular and tradable foreign currency, the local citizens will actuallys tart holding dollars and start transacting in dollars. So, informally, the entire economy is "Dollarized". Such a phenomenon is called Dollarization where nearly the entire country starts using Dollars. It can be an official dollarization when government declares the foreign currency as a legal tender.

and what is a currency board?

Recall the situation we looked at the beginning.

In order to monetarily stabilize the economy, a currency board is constituted that issues local currency only:

1. This local currency is supported fully by the foreign currency.
2. The legal currency can be converted into a foreign currency on demand and at a fixed exchange rate.
3. This foreign currency then becomes the anchor foreign currency.
4. The currency board will have reserves that will be 100% of the total local currency in circulation.