Interestingly enough, not only dollarization, reduces almost completely the scope for monetary policy, but also curtails the ability to pursue fiscal policy. In effect, when debt is denominated in domestic currency the central bank, which acts as the fiscal agent of the treasury, can always monetize it. If we leave for aside for now the consequences of monetization (I’ll deal with that in another post), default in domestic denominated debt is not possible, since monetization is always an option. Dollarization transforms all debt (public and private) into foreign debt, and as the central bank cannot print foreign money (if we rule falsification out), default risk is incremented (supposedly in exchange foreign exchange risk vanishes, since nominal depreciation is impossible in a dollarized economy).
As result, not only contractionary fiscal policy has to be used to reduce the demand for imports if there are external problems, but also the space for domestic spending (not the external transactions that would always require dollars) becomes limited. An external crisis becomes a domestic fiscal crisis.
In most cases, dollarization is forced by market forces (i.e. currency substitution) or is simply the result of a political decision, which can be enforced by authorities that are often in the middle of an external crisis with run away inflation. That was, for example, the case in Ecuador. Interestingly enough El Salvador did not have any significant inflation before dollarization, and the Colón was one of the most stable currencies in Latin America. Also, currency substitution was not widespread, with around 10% of the deposits in dollars by the time of dollarization, while Nicaragua, for example, that did not dollarize had a level of deposit dollarization of more than 50%.
Dollarization in El Salvador can only be understood as part of a larger strategy. Not only is El Salvador dollarized, but also part of the Central American Free Trade Area (CAFTA), a trade a agreement with the US and other Central American countries, and the Dominican Republic. The development strategy is to export people! Yes, immigrants become cheap labor in the US and send remittances (which are almost 19% of GDP, see the graph), and foreign capital enters to produce in maquilas for export, exploiting cheap labor at home. Real wages have been low and declining, the real exchange rate appreciated (but not as much as in other countries with fixed rates), and financial remuneration has gone up.
Domestically, this is the strategy of an elite that decided to accumulate financially and in dollars. Internationally, this is part of the American strategy of integration with the Western Hemisphere, FTAs and financial liberalization, which implies varying degrees of formal and informal dollarization (By the way if the US approves the FTAs with Colombia and Panama, the whole Pacific coast from Chile to Alaska will be part of a FTA, with the exception of Ecuador, which is formally dollarized).