This paper selectively reviews policy and analytical issues related to currency substitution in developing countries. The paper examines, first, whether or not currency substitution should be encouraged; second, how the presence of currency substitution affects the choice of nominal anchors in inflation stabilization programs; third, how changes in the rate of growth of the money supply affect the real exchange rate; fourth, the way in which inflationary finance and currency substitution interact; and, finally, issues related to the empirical verification of the currency substitution hypothesis.
Views differ substantially as to whether or not currency substitution should be encouraged, with some arguing for higher interest rates on domestic money to induce people to hold it, and others making the case for a “full” dollarization of the economy (that is, adopting a foreign currency as the only legal tender, as in Panama). The paper concludes that while there does not seem to be a strong case for either encouraging or discouraging the use of foreign currency, the extreme measure of full dollarization might leave the domestic banking system without a lender of last resort.
As far as inflation stabilization programs are concerned, the presence of currency substitution does not alter, qualitatively, the choice between “recession now versus recession later” when comparing money-based and exchange-rate-based stabilizations. Quantitatively, however, the presence of currency substitution aggravates the initial recession in a money-based stabilization and makes the initial boom more pronounced in an exchange-rate-based stabilization.