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Working Paper 71 - Exchange Rate Policy and Currency Substitution: The Case of Africa’s Emerging Economies
In a large number of emerging and developing economies local currencies do not adequately fulfil the functions of money. Therefore, local residents tend to hold foreign currency-denominated deposits at domestic banks in addition to their local currency deposits. The degree at which a foreign currency takes the role of the local currency reflects the extent of the prevalence of the phenomenon of dollarization or currency substitution: from the extreme case of full dollarization to partial dollarization or some degree of currency substitution. On the one hand, under full dollarization, a foreign currency, such as the dollar, is used as a legal tender instead of the local currency and, consequently, the monetary authorities lose its functions.1 On the other hand, under partial dollarization, local currency is partially substituted by a foreign currency and, therefore, erodes the control of the monetary authorities over its aggregates. The latter describes a situation where the demand for foreign exchange by local residents is no longer tied to foreign trade and transactions requirements but used instead as a store of value and even as the local medium of exchange.