Currency substitution
Full currency substitution can occur after a major economic crisis, such as in Ecuador, El Salvador, and Zimbabwe.
It can also occur as a gradual conversion to full currency substitution; for example, Argentina and Peru were both in the process of converting to the U.S. dollar during the 1990s.
[3] The collapse of "soft" pegs in Southeast Asia and Latin America in the late 1990s led to currency substitution becoming a serious policy issue.
The second is the share of all foreign currency deposits held by domestic residents at home and abroad in their total monetary assets.
The first is the significantly negative effect of exchange rate volatility on trade in most cases, and the second is an association between transaction costs and the need to operate with multiple currencies.
[14] Economic integration with the rest of the world becomes easier as a result of lowered transaction costs and stabler prices.
[15] Countries with full currency substitution can invoke greater confidence among international investors, inducing increased investments and growth.
Adopting a strong foreign currency as legal tender will help to "eliminate the inflation-bias problem of discretionary monetary policy".
[17] Secondly, official currency substitution imposes stronger financial constraint on the government by eliminating deficit financing by issuing money.
[19] The expected benefit of currency substitution is the elimination of the risk of exchange rate fluctuations and a possible reduction in the country's international exposure.
[2][20] For example, former chairman of the Federal Reserve Alan Greenspan has stated that the central bank considers the effects of its decisions only on the US economy.
[13] In addition, monetary authorities in economies with currency substitution diminish the liquidity assurance to their banking system.
[2][23] In an economy with full currency substitution, monetary authorities cannot act as lender of last resort to commercial banks by printing money.
Currency substitution may reduce the possibility of systematic liquidity shortages and the optimal reserves in the banking system.
[28] Research has shown that official currency substitution has played a significant role in improving bank liquidity and asset quality in Ecuador and El Salvador.
The pattern of the currency substitution process also varies across countries with different foreign exchange and capital controls.
[30] Evidence for this pattern is given in the absence of currency substitution during the pre-reform period in most transition economies, because of constricted controls on foreign exchange and the banking system.
However, the effect of this regulation on the pattern of currency substitution depends on the public's expectations of macroeconomic stability and the sustainability of the foreign exchange regime.
