Dollarization Effects on Monetary Policy and Costa Rica's Bands

1. Definition of Dollarization

1. DEFINITION
Dollarization is the process whereby a country adopts the U.S. dollar as a currency for use in economic transactions. Foreign currency replaces the domestic currency in all its functions (store of value, unit of account, means of payment).

Consequences of Dollarization

Dollarization 1. CONSEQUENCES

Impact of informal dollarization

Impact of informal dollarization:

• Makes money demand unstable, complicating the monetary authority's ability to stabilize the economy and control inflation.
• "The informal dollarization creates pressure on the exchange rate, increasing the demand for foreign currency."
• Deterioration of the purchasing power of revenues denominated in the local currency.
• Distortion in interest rates. Rates may become particularly high because the monetary authority cannot effectively stimulate increases in local-currency savings.
• A rapidly deteriorating financial sector, high interest rates, and steady depreciation of the local currency can lead to illiquidity and insolvency.
• Seigniorage revenue is reduced and the recovery of the inflation tax is hampered, because printing money to cover the budget deficit is used by agents to put pressure on the demand for foreign exchange.

Immediate consequences of official dollarization

Immediate consequences of official dollarization:

• Involves an almost immediate recovery of credibility.
• Forces policymakers to adopt fiscal and monetary discipline.
• Reveals structural economic problems, which can promote changes in social structures.

Case: Costa Rica and Exchange Rate Bands

1. THE CURRENT CASE OF COSTA RICA
EXCHANGE RATE BANDS IN COSTA RICA

A rate bands system is a control mechanism. The central bank actively intervenes in the foreign exchange market to prevent the price from exceeding the announced range, selling foreign exchange at the upper limit (ceiling) or buying at the lower limit (floor), so that the exchange rate does not move beyond that value.

However, a narrow band reduces the possibility of exchange rate variation but requires the monetary authority to intervene more actively, exchanging foreign currency for local currency. This helps expand the means of payment in the economy, with the consequential financial costs involved in acquiring foreign currency and increasing the money supply.

Benefits of the exchange rate band system

The benefits brought by this exchange system include:

• Gives some autonomy to monetary policy.
• The exchange rate has more flexibility to respond to internal and external shocks.
• Provides greater stability.
• Reduced interest rates (both deposit and lending rates).
• Helps stabilize the inflation trend.
• Bolsters foreign exchange reserves.
• Builds public and market confidence.

Exchange system disadvantages

Exchange System Disadvantages:

• Transaction exposure.
• Operational or economic exposure.
• Accounting conversion exposure.