Currency substitution is the situation where a country uses a foreign currency. For example, Montenegro and Kosovo unilaterally use the euro, El Salvador and Panama unilaterally use the dollar. In the scenario that a country would be forced to leave an existing currency union (if at all possible), what would be the advantages and disadvantages should this country unilaterally decide to keep using the larger currency?


1 Answer 1


Using a national currency gives you full control over monetary policy while using a larger foreign currency provides stability.

Detailed answer:
If a country has its own currency then the government, or to be more precise the central bank, can intervene and change exchange rates. This might be necessary if the countries products are not competitive on the international markets on the current exchange rates. An example:

Cost of a foreign laptop: 200 USD. Cost of a domestic laptop: 100 Peruvian Nuevo Sol (PEN). The domestic laptop can only be sold if the USD/PEN exchange rate is over 1/2.

In theory the government of a country using a foreign currency could launch policies that would simply reduce all salaries and rents, but this is politically and psychologically undesirable (downward rigidity of wages).

Unless big shocks (drastic events or drastic new information) occur such interventions would not be necessary as prices, wages and exchange rates slowly adjust thanks to the free market.

So a benefit of having a national currency is that it gives a country full control over its monetary policy and this makes such interventions possible. A disadvantage would be that a small nation's currency may be less stable than a large ones, for an example see this question. Stability (or at least predictability) of exchange rates is important for foreign investments and as they have a direct effect on the prices of imported goods and on the profit of export firms it is also important for the citizens of the country.

In the circumstances described there may also be a secondary effect:
A government in control of its monetary policy and facing extremely serious problems may start printing extreme amounts of cash because it turns up indirectly as income in the governments balance sheet (this is known as seigniorage). This can cause undesirable rates of inflation. Most economies avoid this problem by delegating money printing to a central bank which is independent from the government (to some extent). The mandate of the central bank is not to provide the government with income but to stabilize prices so it will probably try not to cause hyperinflation. This however is ultimately a political decision and in drastic times it may be overruled.


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