Editing Currency substitution (section)

==Effects==

===On trade and investment===
One of the main advantages of adopting a strong foreign currency as sole [[legal tender]] is to reduce the transaction costs of trade among countries using the same currency.<ref name="Alesina 2001 381–385">{{cite journal|last=Alesina|first=Alberto|author2=Barro|title=Dollarization|journal=The American Economic Review|year=2001|volume=91|issue=2|pages=381–385|jstor=2677793|doi=10.1257/aer.91.2.381}}</ref> There are at least two ways to infer this impact from data. 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.<ref name="Yeyati 2003 22">Yeyati (2003) at 22.</ref> Economic integration with the rest of the world becomes easier as a result of lowered transaction costs and stabler prices.{{r|Berg 2000}} Rose (2000) applied the [[gravity model of trade]] and provided empirical evidence that countries sharing a common currency engage in significantly increased trade among them, and that the benefits of currency substitution for trade may be large.<ref>{{cite journal|last=Rose|first=Andrew|title=One Money, One Market: the effect of common currencies on trade|journal=Economic Policy|volume=15|issue=30|pages=8–0|year=2000|doi=10.1111/1468-0327.00056}}</ref>

Countries with full currency substitution can invoke greater confidence among international investors, inducing increased investments and growth. The elimination of the currency crisis risk due to full currency substitution leads to a reduction of country risk premiums and then to lower interest rates.{{r|Berg 2000}} These effects result in a higher level of investment. However, there is a positive association between currency substitution and interest rates in a dual-currency economy.<ref>{{cite journal|last=Honohan|first=Patrick|title=Dollarization and Exchange Rate Fluctuations|journal=World Bank Policy Research Working Paper|year=2007|issue=4172|doi=10.1596/1813-9450-4172|series=Policy Research Working Papers|hdl=10986/7252|url=http://www-wds.worldbank.org/external/default/WDSContentServer/WDSP/IB/2007/03/14/000016406_20070314160847/Rendered/PDF/wps4172.pdf |hdl-access=free}}</ref>

===On monetary and exchange rate policies===
Official currency substitution helps to promote fiscal and monetary discipline and thus greater macroeconomic stability and lower [[inflation]] rates, to lower real exchange rate volatility, and possibly to deepen the financial system.<ref name="Yeyati 2003 22"/> Firstly, currency substitution helps developing countries, providing a firm commitment to stable monetary and exchange rate policies by forcing a passive monetary policy. Adopting a strong foreign currency as [[legal tender]] will help to "eliminate the inflation-bias problem of discretionary monetary policy".<ref>{{cite journal|last=Alesina|first=Alberto|author2=Barro|title=Dollarization|journal=The American Economic Review|year=2001|volume=91|issue=2|pages=382|jstor=2677793|doi=10.1257/aer.91.2.381}}</ref> Secondly, official currency substitution imposes stronger financial constraint on the government by eliminating deficit financing by issuing money.<ref>Yeyati (2003) at 23.</ref> An empirical finding suggests that inflation has been significantly lower in economies with full currency substitution than nations with domestic currencies.<ref>{{cite journal |last1=Edwards |first1=Sebastian |last2=Magendzo |first2=I. Igal |title=Dollarization And Economic Performance: What Do We Really Know? |journal=International Journal of Finance and Economics |year=2003 |volume=8 |issue=4 |pages=351–363 |doi=10.1002/ijfe.217 |citeseerx=10.1.1.557.6231 }}</ref> 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. Currency substitution cannot eliminate the risk of an external crisis but provides steadier markets as a result of eliminating fluctuations in exchange rates.<ref name="Berg 2000">{{cite journal|last=Berg|first=Andrew|author2=Borensztein, Eduardo|title=The Pros and Cons of Full Dollarization|journal=IMF Working Paper; Full Dollarization |year=2000|issue=/50 |url=http://www.imf.org/external/pubs/ft/issues/issues24/index.htm |publisher=IMF |access-date=13 October 2011}}</ref>

On the other hand, currency substitution leads to the loss of [[seigniorage]] revenue, the loss of monetary policy autonomy, and the loss of the [[exchange rate]] instruments. Seigniorage revenues are the profits generated when monetary authorities issue currency. When adopting a foreign currency as [[legal tender]], a monetary authority needs to withdraw the domestic currency and give up future seigniorage revenue. The country loses the rights to its autonomous monetary and [[exchange rate]] policies, even in times of financial emergency.{{r|Berg 2000}}<ref name="Broda and Levy Yeyati (2003)">{{cite journal|last=Broda, Levy Yeyati|first=Christian, Eduardo|title=Endogenous deposit dollarization|url=https://ideas.repec.org/p/fip/fednsr/160.html|publisher=Federal Reserve Bank of New York|year=2003}}</ref> 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.<ref name="jcmb1999fall">{{cite journal|url=http://www.drclas.harvard.edu/revista/articles/view/473|title=Dollarization in Latin America: Is it desirable?|author=Moreno-Bird, Juan Carlos|journal=ReVista: Harvard Review of Latin America|date=Fall 1999|access-date=27 June 2012|archive-url=https://web.archive.org/web/20110811035231/http://www.drclas.harvard.edu/revista/articles/view/473|archive-date=11 August 2011|url-status=dead}}</ref> In a full currency substituted economy, [[exchange rates]] are indeterminate and monetary authorities cannot devalue the currency.<ref>{{cite journal|last=John|first=Kareken|author2=Wallace|title=On the Indeterminacy of Equilibrium Exchange Rates|journal=Quarterly Journal of Economics|year=1981|volume=96|issue=2|pages=207–222|doi=10.2307/1882388|jstor=1882388}}</ref> In an economy with high currency substitution, [[devaluation]] policy is less effective in changing the [[real exchange rate]] because of significant pass-through effects to domestic prices.<ref name="Berg 2000"/> However, the cost of losing an independent monetary policy exists when domestic monetary authorities can commit an effective counter-cyclical monetary policy, stabilizing the business cycle. This cost depends adversely on the correlation between the business cycle of the client country (the economy with currency substitution) and the business cycle of the anchor country.<ref name="Alesina 2001 381–385"/> In addition, monetary authorities in economies with currency substitution diminish the liquidity assurance to their banking system.<ref name="Berg 2000"/><ref name="Levy Yeyati (2006)">{{cite book |chapter=Liquidity Insurance in a Financially Dollarized Economy |first=Eduardo Levy |last=Yeyati |title=Financial Markets Volatility and Performance in Emerging Markets |editor-last=Edwards |editor2-last=Garcia |publisher=University of Chicago Press |year=2008 |pages=185–218 |chapter-url=https://www.nber.org/chapters/c4778 |isbn=978-0-226-18495-1 }}</ref>

===On banking systems===
In an economy with full currency substitution, monetary authorities cannot act as [[lender of last resort]] to commercial banks by printing money. The alternatives to lending to the bank system may include taxation and issuing government debt.<ref>{{cite journal|last=Bencivenga|first=Valerie|author2=Huybens, Smith|title=Dollarization and the Integration of International Capital Markets: a Contribution to the Theory of Optimal Currency Areas|journal=Journal of Money, Credit and Banking|year=2001|volume=33|issue=2, Part 2|pages=548–589|jstor=2673916|doi=10.2307/2673916}}</ref> The loss of the lender of last resort is considered a cost of full currency substitution. This cost depends on the initial level of unofficial currency substitution before moving to a full currency substituted economy. This relation is negative because in a heavily currency substituted economy, the central bank already fears difficulties in providing liquidity assurance to the banking system.<ref>{{cite journal|last=Broda|first=Christian|author2=Yeyati|title=Dollarization and the Lender of Last Resort|journal=Book: Dollarization|year=2001|pages=100–131}}</ref> However, 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.<ref>Yeyati (2003) at 31.</ref>

Commercial banks in countries where saving accounts and loans in foreign currency are allowed may face two types of risks:
#Currency mismatch risk: Assets and liabilities on the balance sheets may be in different denominations. This may arise if the bank converts foreign currency deposits into local currency and lends in local currency or vice versa.
#Default risk: Arises if the bank uses the foreign currency deposits to lend in foreign currency.<ref name="Kutan, Rengifo Ozsoz(2010)">{{cite web|last=Kutan, Rengifo, Ozsoz|first=Ali, Erick, Emre|title=Evaluating the Effects of Deposit Dollarization in Bank Profitability|url=http://stage.web.fordham.edu/images/academics/graduate_schools/gsas/economics/dp2010_07_kutan_rengifo_ozsoz.pdf|publisher=Fordham University Economics Department}}{{Dead link|date=July 2019 |bot=InternetArchiveBot |fix-attempted=yes }}</ref>
However, currency substitution eliminates the probability of a [[currency crisis]] that negatively affects the banking system through the [[balance sheet]] channel. Currency substitution may reduce the possibility of systematic liquidity shortages and the optimal reserves in the banking system.<ref>Yeyati (2003) at 34.</ref> Research has shown that official currency substitution has played a significant role in improving bank liquidity and asset quality in Ecuador and El Salvador.<ref>{{Cite web |url=http://www.frbatlanta.org/filelegacydocs/erq306_quispe.pdf |title=Federal Reserve Bank of Atlanta, ''Official Dollarization and the Banking System in Ecuador and El Salvador'', 2006 |access-date=14 September 2012 |archive-url=https://web.archive.org/web/20121019203853/http://www.frbatlanta.org/filelegacydocs/erq306_quispe.pdf |archive-date=19 October 2012 |url-status=dead }}</ref>