Currency boards

Currency boards are fixed exchange rate regimes with an additional feature: the central bank has to keep large foreign exchange reserves. Specifically, the reserves have to be large enough to cover all the money in circulation and the deposits that commercial banks keep at the central bank. For example, if the currency in circulation and deposits add up to 100 billion Argentine peso and the exchange rate of the peso to the dollar is 10 peso = 1 dollar, then the reserves have to be 10 billion dollars.

That reserves requirement makes the fixed exchange rate “credible”, i.e. people should believe that the fixed exchange rate will be maintained indefinitely without risk of devaluation. The reason is that even if all people wanted to exchange their domestic currency for dollars, they would be able to do so at the fixed exchange rate.

The benefit of currency boards is that they deliver low and stable inflation. Because the exchange rate is fixed, international products have stable prices coming into the economy. That gives an "anchor" to the prices of domestic products as well.

The problem with the currency boards is that they eliminate monetary policy. The central bank has to keep money supply in line with the foreign exchange reserves. It cannot manipulate the money supply or the interest rates. As a result, it loses one of the important tools to fight recessions.

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