and safety nets in foreign currency such as deposit insurance can all be evaluated under this framework. due to those imperfections, moral hazard problems arise and this in turn results in a larger demand for foreign currency. as the studies 3 have showed, the low quality of legal and political institutions and the lack of legal protection for domestic creditor provide incentives for dollarization. dear guests, now, the question is why we should care about dollarization. before anything else, it increases a country ’ s vulnerability to shocks. let me also mention the vulnerabilities of two major sectors in an economy : one arising from dollarization in private sector and the other one having to do with dollarized public debt dynamics. beginning with the private sector, the dollarized financial systems and the companies ’ balance sheets are obviously exposed to solvency risks, due to currency mismatch problem. keeping in mind that the risks for both financial and real sectors are interrelated, the banks that lend in foreign currency to firms, which earn revenues in domestic currency, are also indirectly affected. in such cases, the whole economy becomes more vulnerable to shocks due to amplified risks resulting from dollarization. a recent strand of literature and country cases such as the asian meltdown of 1997 and the 2000 - 2001 banking crisis in turkey, have all emphasized the importance of such vulnerabilities brought about by dollarization. moreover, firms adjust their prices more frequently in a dollarized economic environment where depreciation of national currency is perceived as permanent. thus, dollarization leads to higher pass through effect from exchange rates to prices via deteriorating pricing behaviour of firms. ultimately, from the public sector ’ s point of view, the issue of debt sustainability is highly influenced by dollarization. in fact, public sector is exposed to problems similar to that of non - trading firms indebted in foreign currency 4. there is no doubt that dollarized debt adversely affects government ’ s solvency as its assets are in domestic currency. in this sense, given the high level of dollarization, the fluctuations in real exchange rate might turn an apparently sustainable fiscal situation into an unsustainable one. furthermore, public sector insolvency can immediately lead to banking sector insolvency if domestic banking system holds large claims against government. dear guests, before continuing with the turkish experience, i have to add that dollarization deserves a special attention from a central banker ’ s perspective. as we all know, the choice of exchange rate regime is

rates among their currencies or, even better, by forming a currency union. 4 however, in practice, empirical analyses have generally been unsuccessful at identifying multi - country regions of any size that meet the criteria for an optimum currency area. indeed, some studies have concluded that even the united states and the european union, the largest currency unions, are themselves not optimum currency areas. 5 plausibly, political rather than economic considerations - namely, the desire to form a more perfect union - underlay the decisions of each of these entities to adopt a common currency. 6, 7 besides countries well - suited for a currency union, a second group of countries that might conceivably be better off with a fixed exchange rate, at least for a time, are the very poorest and least developed countries, which may lack the institutional infrastructure to effectively operate an independent monetary policy. in these countries, a hard peg or even the adoption of the currency of a major trading partner - sometimes known as dollarization, although the term also refers to cases in which the currency adopted is one other than the dollar - may be policy options worth considering. ( i want to be clear that i am speaking generally and am not advocating that other countries adopt the u. s. currency. ) although dollarization has the advantage of making monetary policy essentially automatic and should be an effective device for controlling inflation, one is struck by the fact that so few countries have chosen this approach. costs of dollarization include the loss of revenue from money creation and the reduced ability of the central bank to serve as a lender of last resort. but perhaps the most important impediment to dollarization is that, in giving up their own currency, the country ’ s citizens may feel that they are losing an important symbol of the nation ’ s sovereignty and pride. for other developing and emerging - market countries, i would argue that the best course is generally to let the exchange rate float freely and to make low and stable inflation a principal focus of monetary policy. as i have already suggested, this approach makes the targeted inflation rate, and not the exchange rate or some other variable, the nominal anchor of the system. an important reason for making the inflation rate ( more precisely, the price level ) the nominal anchor is that the general price level is more directly linked to economic welfare than is the exchange rate. domestic price stability improves the operation of markets, reduces the costs associated with economizing on money holdings and with