Wurtz 9
In contrast to the portfolio approach, transaction based explanation views the demand for
money to arise from its use as a medium of exchange. Thus, a currency is only as useful as it is
widely accepted. Handa (2000:208) notes that unlike the portfolio approach, transaction models
accept that bonds are not accepted as a medium of exchange, and thus are not good substitutes
for the domestic currency. The substitutability of a currency, then, depends on the scope of its
acceptance and the transaction costs of switching. One interesting aspect of de facto
dollarization is that the foreign currency often maintains a high level of market penetration, even
after the macroeconomic situation stabilizes. Dowd and Greenaway (1993) attribute the
persistence of de facto dollarization to network externality effects and switching costs. As a
medium of exchange, the utility of a particular form of money increases with the number of
agents holding said currency. This implies that the more a country relies on trade (i.e., the larger
the effective network externality) the more likely it would be that residents would demand the
ability to maintain FC deposits.
Finally, the decision to allow FC deposits is a form of capital control, thus the decision to
allow them could be an aspect of a broader process of capital account liberalization, rather than
related to the dollarization process itself. While some work has been done on the political
economy of capital account liberalization, it remains an underdeveloped literature (Eichengreen
2001) and most work has focused on controls aimed at controlling the international flow of
capital. The decision to allow FC deposits, however, is aimed only at a domestic audience and is
likely to require different types of explanation than those typically used in studying capital
controls. Thus, it is important both to understanding the process of dollarization as well as
capital account liberalization. Second, my approach encompasses the broad process of
Convention