Dollarization

A student from Colgate University emails me a question:

I recently went to El Salvador, and I noticed that the currency is the U.S. Dollar. So, I was wondering if the U.S. Federal Reserve policies affect inflation in El Salvador? And, also how does the Central Bank of El Salvador control the money supply? Do they have a covenant with the Fed?

Your question is answered in this excerpt from my intermediate macro textbook:

Speculative Attacks, Currency Boards, and Dollarization

Imagine that you are a central banker of a small country. You and your fellow policymakers decide to fix your currency--let's call it the peso--against the U.S. dollar. From now on, one peso will sell for one dollar.

As we discussed earlier, you now have to stand ready to buy and sell pesos for a dollar each. The money supply will adjust automatically to make the equilibrium exchange rate equal your target. There is, however, one potential problem with this plan: you might run out of dollars. If people come to the central bank to sell large quantities of pesos, the central bank's dollar reserves might dwindle to zero. In this case, the central bank has no choice but to abandon the fixed exchange rate and let the peso depreciate.

This fact raises the possibility of a speculative attack--a change in investors' perceptions that makes the fixed exchange rate untenable. Suppose that, for no good reason, a rumor spreads that the central bank is going to abandon the exchange-rate peg. People would respond by rushing to the central bank to convert pesos into dollars before the pesos lose value. This rush would drain the central bank's reserves and could force the central bank to abandon the peg. In this case, the rumor would prove self-fulfilling.

To avoid this possibility, some economists argue that a fixed exchange rate should be supported by a currency board, such as that used by Argentina in the 1990s. A currency board is an arrangement by which the central bank holds enough foreign currency to back each unit of the domestic currency. In our example, the central bank would hold one U.S. dollar (or one dollar invested in a U.S. government bond) for every peso. No matter how many pesos turned up at the central bank to be exchanged, the central bank would never run out of dollars.

Once a central bank has adopted a currency board, it might consider the natural next step: it can abandon the peso altogether and let its country use the U.S. dollar. Such a plan is called dollarization. It happens on its own in high-inflation economies, where foreign currencies offer a more reliable store of value than the domestic currency. But it can also occur as a matter of public policy, as in Panama. If a country really wants its currency to be irrevocably fixed to the dollar, the most reliable method is to make its currency the dollar. The only loss from dollarization is the seigniorage revenue that a government gives up by relinquishing its control over the printing press. The U.S. government then gets the revenue that is generated by growth in the money supply.

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The CIA reports that El Salvador dollarized in 2001. Now, when the Fed set monetary policy for the U.S. economy, it also set monetary policy for the economy of El Salvador.

If you want to read more on the topic, here in an article I wrote about dollarization for Fortune magazine, here is an article from the Federal Reserve Bank of Atlanta, and here is an article from the IMF.

The best summary of the issues is found in this limerick from Bob McTeer, former President of the Dallas Fed:

There once was a hyperactive central banker
Whose boat needed a stronger anchor.
The ocean was big,
The boat was small,
So he tied his anchor to a tanker.