What Is a Currency Board System? What Are the Strengths

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The Answer is A currency board system is an exchange-rate system where the value of the currency is irrevocably fixed to the value of another currency. In this sense, it is similar to the exchange control system. However there is a major difference. In this system, the central bank holds no domestic currency, only foreign currency. Before a country adopts a currency board system, it is prudent to examine the strengths and limitations of such a system. Essentially, a currency board helps to stabilize the exchange rate by ensuring that the money supply is fully backed by foreign exchange reserves. Like any exchange rate peg, a currency board makes a commitment to fix the value of the domestic currency relative to a foreign currency. With full backing, the currency board is able to make this commitment believable because it is able to redeem domestic currency for foreign currency at a fixed rate. However, the resulting stability carries a price. Most important is the fact that a country loses independent control of its monetary policy. In this case, the country is tying its economic fate to that of the foreign currency to which it is pegged. Without independence, the monetary authority also loses its ability to serve as a lender of last resort during a liquidity crisis. All monetary authorities seek credibility, whether through reputation, explicit inflation targets, or exchange rate pegs. Currency boards help to establish credibility by ensuring full currency backing. Another characteristic of a currency board is that it is prohibited from buying or holding domestic treasury or commercial securities. Since a currency board is constrained to issue currency only in exchange for the reserve currency, it is powerless to create domestic money by extending credit as conventional central banks can do. Strict limits on a currency board's power to issue money constrain its operations in two important respects: the board cannot finance (i.e., monetize) the government's budgetary deficits and it cannot regulate the nation's money supply by engaging in open market operations. It is these two constraints that attract the most determined opposition to the currency board idea and at the same time inspires its greatest admiration. Currency boards are one particular monetary arrangement among many for establishing and maintaining confidence in a national currency, but they may not be the best choice in all situations.

What Is a Currency Board System? What Are the Strengths

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What Is a Currency Board System? What Are the Strengths

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