Smuggling, Currency Substitution and Unofficial Dollarization

Abstract

Large stocks of U.S. dollars and other hard currencies circulate in the transition economies, in Latin America, and in other countries that have experienced macroeconomic mismanagement. Using a monetary model that combines the legal restrictions and crime-theoretic traditions, this paper demonstrates how leaky exchange controls lead to currency substitution and progressive dollarization. The paper also analyzes the impact of dollarization on the ability of governments to earn seigniorage, the dynamics of dollarization in a growing economy, and the central role of expectations—specifically, confidence in the domestic currency—in determining the extent of dollarization and, potentially, in reversing it.Smuggling;Currency substitution;Dollarization;foreign currency, equation, difference equation, probability, optimization, inflation, equations, monetary economics, price level, black market, terms of trade, foreign exchange, rate of inflation, monetary policy, time series, real value, macroeconomic analysis, aggregate demand, quantity theory, real money, money supply