Smuggling, Currency Substitution and Unofficial Dollarization: A Crime-Theoretic Approach

IMF Working Papers, October 1, 2000

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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.

Leaky exchange controls create incentives for currency substitution and progressive dollarization, as formal restrictions are circumvented.
Dollarization reduces the ability of governments to earn seigniorage.
In a growing economy, dollarization exhibits dynamic behavior that the model captures.
Expectations and confidence in the domestic currency play a central role in determining the extent of dollarization and the possibility of reversing it.

Subject: Anti-smuggling, Currencies, Currency markets, Dollarization, Financial institutions, Financial markets, Monetary policy, Money, Revenue administration, Stocks
Keywords: Anti-smuggling, Currencies, currency balance, Currency markets, Currency Substitution, Dollarization, Europe, export proceeds, fiat currency, foreign currency, hard currency, hard currency stock, home-country currency market, law of motion, Middle East, Seigniorage, Smuggling, Stocks, WP