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What is currency substitution?

What is currency substitution?

Currency Substitution can be an official or ad hoc occurrence in a country whose commerce is partially, or fully, conducted using the currency of another country.

Some currencies which are pegged to another currency at a fixed rate (especially at whole integers) are domestically exchanged in the same manner that the local currency is. Many countries have completely adopted the currency of another country, and do not have a central bank of their own.

Others have their own currency and a central bank, but business in the country is conducted often using the currency of another country. This may be done simply for convenience, if there is a lot of liquid foreign currency around for whatever reason, or it may be done because citizens have more faith in the value of the foreign currency.

This may happen where a local currency is pegged to a foreign currency, or in countries with floating exchange rates. Substitution may happen gradually or all at once if regulations change suddenly, and the change may be part of official central bank policy, such as weaning the country off of their domestic currency before fully adopting the foreign one, or just in an ad hoc manner.

Currency substitution essentially means that a foreign currency is used as a medium of exchange in local business. The US Dollar (USD) is the international reserve currency, and around 65 countries have either pegged their currency to the dollar or use the dollar as their own currency.

When a country gradually adopts the US dollar as their currency, it is known as dollarization.

Keywords: monetary policy, central banks, fixed currency, pegged currency, dollarization, currency peg,