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Dollarization occurs when the inhabitants of a country use foreign currency in parallel to or instead of the domestic currency as a store of value, unit of account, and/or medium of exchange within the domestic economy. The term is not only applied to usage of the United States dollar, but generally to the use of any foreign currency as the national currency. There are two common indicators of dollarization. The first one is the share of foreign currency deposits (FCD) in the domestic banking system in the broad money including of FCD. The second measure is the share of all foreign currency deposits held by domestic residents at home and abroad in their total monetary assets.

The biggest economies to have officially dollarized as of June 2002 are Panama (since 1904), Ecuador (since 2000), and El Salvador (since 2001). , the United States dollar, the Euro, the New Zealand dollar, the Swiss franc, the Indian rupee, and the Australian dollar were the only currencies used by other countries for official dollarization. In addition, the Armenian dram, Turkish lira, the Israeli shekel, and the Russian ruble are used by internationally unrecognized but de facto independent states.

Origins
After the gold standard was abandoned at the outbreak of World War I and the Bretton Woods Conference following World War II, some countries were desperately seeking exchange rate regimes to promote global economic stability and hence their own prosperity. Countries usually peg their currency to a major convertible currency. "Hard pegs" are extreme exchange rate regimes that demonstrate a stronger commitment to a fixed parity (i.e currency boards) or relinquish control over their own currency (such as currency unions and dollarization) while "soft pegs" are more flexible and floating exchange rate regimes. When countries choose to use a major convertible currency parallel to or in place of their national currency, this is called the process of dollarization. The collapse of "soft" pegs in Southeast Asia and Latin America in the late 1990s led dollarization to become a serious policy issue.

A few cases of full dollarization until 1999 had been the consequence of political and historical factors. In all long-standing dollarization cases, historical and political reasons have been more influential than an evaluation of the effects of dollarization. Panama, the most salient dollarization example, adopted the U.S. dollar as legal tender after its independence as a result of a constitutional ruling. Ecuador and El Salvador have become full dollarized economies since 2001 and 2001 respectively with different influential factors. Ecuador underwent the process of dollarization to deal with a widespread political and financial crisis resulted from massive loss of credibility in its political and monetary institutions. In contrary, El Salvador's official dollarization was as a result of internal debates and in a context of stable macroeconomic fundamentals and long-standing unofficial dollarization. The euro area have adopted the euro (€) as their common currency and sole legal tender since 1999, which might be considered as a variety of a full-commitment regime similar to full dollariation despite of some differences distinguishable from other dollarization.

On trade and investment
One of the main advantages of adopting of a strong foreign currency as sole legal tender is reducing the transaction costs of trade among countries using the same currency. There are at least two ways to infer this impact from data. The first one is a significantly negative effect of exchange rate volatility on trade in most cases and the second is a association between transaction costs and the need to operate with multiple currencies. Economic integration with the rest of the world becomes easier as a result of lowered transaction costs and more stable prices in dollar terms. Rose (2000) applied the gravity model of trade and provide empirical evidence that countries sharing a common currency engage in significantly increased trade among them and the benefits of dollarization for trade may be large.

Dollarized economies can invoke greater confidence among international investors inducing increased investments and growth. The elimination of the currency crisis risk due to full dollarization will lead to a reduction of country risk premia and then lower interest rates. These effects will result in a higher level of investment. However, it is evident that there is a positive association between dollarization and interest rates in a dual-currency economy.

On monetary and exchange rate policies
Official dollarization helps promote greater fiscal and monetary discipline and thus greater macroeconomic stability and lower inflation rates, lower real exchange rate volatility, and possibly deeper the financial system. Firstly, dollarization helps developing countries providing a firm commitment to stable monetary and exchange rate policies by forcing a passive monetary. Adopting a strong foreign currency as legal tender will helps to "eliminate the inflation-bias problem of discretionary monetary policy". Secondly, official dollarization also imposes stronger financial constraint on the government by eliminating financing of the deficit by issuing money. An empirical finding suggests that inflation has been significantly lower in dollarized nations than in non-dollarized ones. The expected benefit of dollarization is the elimination of risk of exchange rate fluctuations and possible reduction in the country's international exposure. Though dollarization cannot eliminate the risk of an external crisis, it provides steadier markets as a result of elimination of fluctuations in exchange rates.

On the other hand, dollarization leads to the loss of seigniorage revenue, the loss of monetary policy autonomy, and the loss of the exchange rate instruments. Seigniorage revenue are the profits when the monetary authorities issue its currency. When adopting a foreign currency as legal tender, the monetary authorities need to withdraw its domestic currency and give up future seigniorage revenue. The country losses the rights to its autonomous monetary and exchange rate policies even in times of financial emergencies. In a full dollarized economy, exchange rates are indeterminate and the monetary authorities can not devalue. In a highly dollarized economy, devaluation policy is less effective in achieving changes in the real exchange rate because of having a high degree of pass-through effects to domestic prices. However, the cost from losing an independent monetary policy exists when the domestic monetary authorities can commit an effective countercyclical monetary policy stabilizing the business cycle. This cost depends adversely on the correlation between business cycle of the client country (dollarized economy) and business cycle of the anchor country. In addition, the monetary authorities in dollarized economies diminish the liquidity assurance to its banking system.

On banking systems
In a fully dollarized economy, the monetary authorities can no longer to provide lender of last resorts to banks by printing money. The alternatives to lend to the bank system might include the use of taxation and the issuance of government debt. The loss of lender of last resort is considered as one cost of full dollarization. This cost depends on the initial level of unofficial dollarization before moving toward a full dollarized economy. This relation is negative because in a heavily dollarized economy, its central bank already fears difficulties to provide liquidity assurance to its banking system. However, the literature points out the existence of alternative mechanisms to provide liquidity insurance to banks such as a scheme by which the international financial community charges an insurance fee in exchange for a commitment to lend to a domestic bank.

Commercial banks in countries where saving accounts and loans in foreign currency are allowed may face two types of risks: However, dollarization eliminates the probability of a currency crisis that impacts negatively on the banking system through the balance sheet channel. Dollarization may reduce the possibility of systematic liquidity shortages and the optimal reserves in the banking system.
 * 1) Currency Mismatch Risk: Assets and liabilities on the balance sheets may be in different denomination. This may arise if the bank converts foreign currency deposits into local currency and lends in local currency or vice versa.
 * 2) Default risk: Arises if the bank uses the foreign currency deposits to lend in foreign currency.

Types
Dollarization can occur in a number of situations. The most popular type of dollarization is unofficial dollarization or de facto dollarization. Unofficial dollarization happens when residents of a country choose to hold a significant share of their financial assets denominated in foreign currency although the foreign currency lacks the legal tender. They hold deposits in the foreign currency because of a bad track record of the local currency, or as a hedge against inflation of the domestic currency.

Official dollarization or full dollarization happens when a country adopts a foreign currency as its sole legal tender, and ceases to issue the domestic currency. Another effect of a country adopting a foreign currency as its own is that the country gives up all power to vary its exchange rate. There is a small number of countries adopting a foreign currency as legal tender. For example, Panama underwent a process of full dollarization by adopting the U.S. dollar as legal tender in 1904. This type of dollarization is also known as de jure dollarization.

Dollarization can be used semiofficially (or officially bimonetary systems), where the foreign currency is legal tender alongside the domestic currency.

In literature, there is a set of related definitions of dollarization such as external liability dollarization, domestic liability dollarization, banking sector's liability dollarization or namely deposit dollarization and credit dollarlization. The external liability dollarization measures total external debt] (private and public) denominated in foreign currencies of the economy. . In addition, based on the measurement of dollarization, dollarization can be classified as deposit dollarization and credit dollarization. Deposit dollarization can be measured as the share of dollar deposit in total deposit of the banking system while credit dollarization can be measured as the share of dollar credit in total credit of the banking system.

The dynamics of the flight from domestic money
High and unanticipated inflation rates decrease the demand for domestic money and raise the demand for alternative assets including foreign currency and assets dominated by foreign currency. This phenomenon is called as flight from domestic money. The flight from domestic money results in a rapid and sizable process of dollarization. In high inflation countries, the domestic currency tends to be gradually displaced by a stable currency such as the U.S. dollar. At the beginning of this process, the store-of-value function of domestic currency will be replaced by the foreign currency. Then, the unit-of-account function of domestic currency will be displaced when many prices are quoted in a foreign currency. A prolonged period of high inflation will induce the domestic currency to lose its function as medium of exchange when the public carrying out many transactions in foreign currency.

Institutional factors
The availability of the option of holding foreign currency deposits in domestic banks; the public's expectations. The flight from domestic money will depend on the country's institutional factors. The first factor is the development level of domestic financial market. An economy with a well-developed financial market can offer a set of alternative financial instruments dominated in domestic currency which reduces the role of foreign currency as an inflation hedge. The pattern of dollarization process also varies across countries with different foreign exchange and capital controls. In a country with strict foreign exchange regulations, the demand for foreign currency will be satisfied in the holding of foreign currency assets abroad and outside the domestic banking system. This demand often puts pressure on the parallel market of foreign currency and on the country's international reserves. One evidence of this pattern is the absence of any dollarization during the pre-reform period in most transition economies because of the constrict controls on foreign exchange and the banking system. In contrary, by facilitating the domestic holding of foreign currency, a country might mitigate the shift of assets abroad and contribute to strengthen its external reserves in exchange for a dollarization process. However, the effect of this regulation on the pattern of dollarization depends on the public's expectations of macroeconomic stability and the sustainability of the foreign exchange regime.

Countries using the U.S. dollar exclusively

 * British Virgin Islands
 * Caribbean Netherlands (from 1 January 2011)
 * East Timor (uses its own coins)
 * Ecuador (uses its own coins in addition to U.S. coins) Ecuador adopted the U.S. dollar as its legal tender in 2000.
 * El Salvador
 * Marshall Islands
 * Federated States of Micronesia (Micronesia used the U.S. dollar since 1944 )
 * Palau (Palau adopted the U.S. dollar since 1944 )
 * Panama (uses its own coins in addition to U.S. coins. This country has adopted the U.S. dollar as legal tender since 1904.
 * Puerto Rico
 * Turks and Caicos Islands

Countries using the U.S. dollar alongside other currencies

 * Bahamas
 * Nicaragua
 * Cambodia 	(uses Cambodian Riel for many official transactions but most businesses deal exclusively in dollars)
 * Lebanon (along with the Lebanese pound)
 * Liberia (was fully dollarized until 1982 the year the National Bank of Liberia started to issue five dollar coins
 * U.S. dollar still in common usage alongside Liberian dollar)
 * Zimbabwe
 * Haiti uses the U.S Dollar alongside its domestic currency called "Gourde"

Euro

 * Andorra (formerly French franc and Spanish peseta since 1278 )
 * Kosovo
 * Monaco (formerly French franc since 1865 ; issues its own euro coins)
 * Montenegro (formerly German mark and Yugoslav dinar)
 * San Marino (formerly Italian lira; issues its own euro coins)
 * Vatican City (formerly Italian lira; issues its own euro coins)

New Zealand dollar

 * Cook Islands (issues its own coins and some notes)
 * Niue
 * Pitcairn Island
 * Tokelau

Australian dollar

 * Kiribati (issues its own coins; Kiribati has used the Australian dollar since 1943 )
 * Nauru(was fully dollarized since 1914 ).
 * Tuvalu (issues its own coins; Tuvalu has used the Australian dollar alongside its domestic currency since 1892 )

South African rand

 * Lesotho
 * Namibia
 * Swaziland

Zimbabwe
Due to the hyperinflation and official abandonment of the Zimbabwean dollar several currencies are used instead:
 * British Pound Sterling
 * Botswana pula
 * Euro
 * South African rand
 * United States dollar

The U.S. dollar has been officially adopted for all transactions involving the new power-sharing government.

Others

 * Armenian dram: Nagorno-Karabakh Republic
 * Russian ruble: Abkhazia and South Ossetia (de facto independent states, but recognized as part of Georgia by nearly all other states)
 * Indian rupee: Bhutan and Nepal
 * Swiss franc: Liechtenstein
 * Israeli shekel: Palestinian territories
 * Turkish lira: Turkish Republic of Northern Cyprus (de facto independent state, but recognized as part of Cyprus by all states but Turkey)