Definition
A Currency Board is a monetary authority that is designed to maintain a fixed exchange rate with a foreign currency. It does this by holding reserves of foreign currency equivalent to its own currency in circulation. This system limits the scope for the central bank to implement independent monetary policy.
Key Takeaways
- A Currency Board is a monetary authority which is focused on maintaining a fixed exchange rate with a foreign currency. This is achieved by holding foreign currency reserves in parity with the country’s own currency.
- Due to the strict exchange rate regime, a country with a Currency Board does not have a traditional monetary policy. This results in fiscal discipline, as the Currency Board cannot print money freely to finance government budget deficits or to bail out insolvent commercial banks.
- While a Currency Board can provide stability, it can also make a country more vulnerable to economic issues in the country it is pegged to. As such, currency boards may limit the flexibility of monetary policy in responding to economic shocks.
Importance
A Currency Board is a crucial financial institution whose primary objective is to control and stabilize the country’s currency against an external standard.
It is crucial because it offers robust fiscal discipline by pegging the local currency to a foreign currency at a fixed exchange rate, maintaining high reserves to back the issued monetary base.
This establishes confidence in the currency and stabilizes the economy by mitigating inflation.
Additionally, by providing a level of predictability in the economic landscape, it tends to attract foreign investment, which can spur economic growth and development.
Therefore, the role of a currency board is vital in maintaining economic stability, attracting foreign investment, and fostering economic growth.
Explanation
A Currency Board is designed to instill financial discipline and economic stability within a country’s economy. Its primary purpose is to maintain a fixed exchange rate with a foreign currency, which it achieves by holding reserves of the foreign anchor currency equivalent to 100% of the domestic currency issued.
This system brings monetary credibility by reducing the risk of economic instability caused by exchange rate fluctuations and inflation. Different from a central bank, a currency board is committed to convert domestic currency on demand into another currency at the fixed exchange rate, it cannot act as a lender of last resort and regulate monetary policies autonomously.
By pegging the domestic currency to a foreign one, the board helps establish confidence, both internally and externally, in a country’s economy. This could be especially beneficial for economies with a history of instability as the board’s rigidity inhibits the government’s ability to tamper with monetary policy for political reasons.
Furthermore, tying the domestic currency to a foreign one with low inflation can help to import monetary stability and low inflation levels. However, the disadvantage is a loss of control over their independent monetary policy, making adjustments in times of economic crises more challenging.
Examples of Currency Board
The Hong Kong Monetary Authority: The Hong Kong Monetary Authority functions as a currency board and has been in operation since October
It has been particularly successful in maintaining stability in Hong Kong’s financial system by keeping the currency pegged to the US dollar.
Bulgarian National Bank: After Bulgaria faced a financial crisis in the 1990s, they established a Currency Board in
The currency, Bulgarian Lev, has been pegged to the Euro to maintain a stable exchange rate and curb inflation.
The Central Bank of Bosnia and Herzegovina: Established as a Currency Board in 1997 after the Bosnian war, this central bank maintains the Bosnian Convertible Marka pegged to the Euro, ensuring financial stability in the aftermath of a significant political and economic upheaval.
Frequently Asked Questions about Currency Board
1. What is a Currency Board?
A Currency Board is a monetary authority which seeks to maintain absolute stability of the exchange rate with a foreign currency by backing its issued domestic currency notes and coins with foreign currency reserves.
2. What is the purpose of a Currency Board?
The purpose of a Currency Board is to instill confidence in the economy. It maintains currency stability, reduces inflation rates, and can foster greater predictability in exchange rates for international transactions.
3. Why does a country use a Currency Board?
Countries opt for a Currency Board when they want to establish monetary stability, particularly those with a history of instability. Countries with Currency Boards promise to convert their domestic currency on demand and at an exchange rate fixed with a major foreign currency.
4. What is the difference between a Currency Board and a Central Bank?
A Currency Board only has a currency policy – to maintain a fixed exchange rate with the foreign currency. It does not have a monetary policy function (like a Central Bank) where it is able to manipulate local interest rates or lending standards.
5. Can a Currency Board fail?
Yes, a Currency Board can fail. If there is a lack of confidence in the arrangement, it can lead to a rush on the reserves and result in the collapse of the currency. To avoid this, the credibility and management of the Currency Board, as well as adequate levels of reserves are crucial.
Related Entrepreneurship Terms
- Fixed Exchange Rate
- Monetary Authority
- Foreign Exchange Reserves
- Pegged Currency
- Financial Stability
Sources for More Information
- International Monetary Fund (IMF): A comprehensive source of financial information and resources, offering insights into currency boards among other monetary aspects.
- World Bank: A leading international institution dedicated to providing finance and advice for countries at different stages of development, it offers deep insights to currency boards.
- Investopedia: This is an extensive online resource dedicated to investing and personal finance, giving detailed explanations of currency boards and other monetary terms.
- Bank for International Settlements (BIS): This international financial organization serves as a bank for central banks and offers information about currency boards.
