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Currency Boards - How a Currency Board Works

Essay 2009 9 Pages

Economics - Monetary theory and policy

Excerpt

Table of Contents

1 Introduction

2 How a Currency Board Works

3 Analysis of The Currency Board-Like System in Argentina

4 Conclusion and Outlook

List of Literature

List of Figures

Fig. 1: The impossible trinity of monetary policy

Fig. 2: Exchange Rate and Inflation in Argentina

Fig. 3: Debts of Argentina in % of GDP, small numbers: in bn US $

List of Tables

Tab. 1: A typical currency board versus a typical central bank

Tab. 2: Argentina before and after setting up a currency board

Tab. 3: Modern currency board systems

Abbreviations

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1 Introduction

„Stability might not be everything, but without stability everything is nothing.“ This quote of the former federal minister for economics and finance in Germany leads directly to the reason for the installation of a currency board.

Stability of the monetary system means the achievement of three objectives: a fixed exchange rate system to alleviate the calculations for international trade, free capital movement to ensure the convertibility of currencies, and a monetary policy that can address independently domestic concerns like inflation or unemployment. Unfortunately, it is impossible to achieve all three objectives at the same time, as can be shown with a simple example:

"A country must pick two out of three. It can fix its exchange rate without emasculating its central bank, but only by maintaining controls on capital flows (like China today); it can leave capital movement free but retain monetary autonomy, but only by letting the exchange rate fluctuate (like Britain--or Canada); or it can choose to leave capital free and stabilize the currency, but only by abandoning any ability to adjust interest rates to fight inflation or recession (like Argentina today, or for that matter most of Europe)." (Krugman 1999)

This goal conflict, illustrated in Figure 1, is often called "triangle of impossibility" or "impossible trinity" in the international economics literature. If a country's decision is to fix the exchange rate to a selected currency, a currency board would be one of the possible instruments. In this essay, first there will be taken a short look at

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Fig. 1: The impossible trinity of monetary policy (source: own illustration)

how a currency board works and what the political meanings and consequences are. Afterwards, a short analysis of the currency board-like system that has been installed in Argentina from 1991 to 2002 will lead to the drawbacks and opportunities of currency boards in the conclusion and outlook section.

2 How a Currency Board Works

If political circumstances require the stabilization of the monetary system of a country, the state can arrange a currency board as monetary authority to target lacks of transparency and commitment. E.g., the national currency has not performed as well as the major internationally traded currencies on the long run. A big advantage compared to other solutions is the unilateral character of a currency board; the troubleshooting country is not reliant on the cooperation of an other country.

The institutional arrangement of a currency board contains basically two actions: the monetary base M0[1] of the domestic currency is backed 100 % by a selected foreign currency and the foreign currency serves as anchor currency with a fixed exchange rate, guaranteed by the note issuing authority of the country. To ensure all holders of notes and coins the convertibility into the anchor currency, usually the reserves constitute about 110 to 115 % of the monetary base. A currency board can be established as a separate monetary authority, but also a central bank can be bound by currency board rules, if the monetary authority of a state is a central bank (Hanke 2002a: 88). In Table 1 it is figured out what the distinctions between an orthodox currency board and a typical central bank are.

In an orthodox currency board- arrangement no other discretionary monetary policy will take place: On the one hand, the currency board is the monetary policy itself and there will follow some adjustments and “passive and automatic” operations. On the other hand, discretionary monetary policy is always situational selected and brings uncertainty for the market actors. This is contradictory to the aims of currency boards as described above. Hanke (2002b: 205) points out that an

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Tab. 1: A typical currency board versus a typical central bank (source: Hanke 2002a: 90)

orthodox currency board would not especially serve as lender of last resort[2], regulate commercial banks and finance spending by domestic government. To cover public spending, bonds must be sold. This reduces the money supply because the quantity of the domestic currency in the currency board system is determined by its demand and supply; similar to the gold standard in earlier decades.

This is the first way how a currency board system faces inflation. An increase of the amount of domestic currency is capped to the amount of the anchor currency.

The second way is a price mechanism. If domestic prices rise, import goods become cheaper and export goods more expensive. As the amount of exports abates, the inflow of foreign currency abates and this also caps the increase of the quantity of domestic currency (Wolff 2003: 4).

3 Analysis of The Currency Board-Like System in Argentina

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Fig. 2: Exchange Rate and Inflation in Argentina (source: Schweickert 2002: 12)

When Carlos Menem was elected President of Argentina in 1989, he inherited a bad conditioned economy from the parent government. He covered the problems with neoliberal reforms and privatizations, supported by the IMF, and enacted the convertibility law: From April 1, 1991 to January 10, 2002, after bouts of hyperinflation and recession, the Argentinian central bank pegged the peso to the US $ (1 $ = 1 ARS). Hanke (2002b: 204 et sqq.), who was advisor in the years 1995 and 1996 to the then Argentinian economics minister Cavallo, describes this system as a currency board- like system, because there can be found several deviations from orthodox currency board rules.

Figure 2 and Table 2 show the development of the Argentinian economy after installing the currency board-like system. In the first years, until 1994, the new policy was very successful (cp. e.g. Grimm 2007: 44 et sqq.); the hyperinflation could be bound and the economy started growing. Even the Tequila Crisis in 19943 did not harm the positive development. After 1998, Argentina was again in economic decline which ended in an almost three year long recession. In 2002, with the termination of the dollar peg, the more and more overvalued peso started a free fall and was devaluated 40%.

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Tab. 2: Argentina before and after setting up a currency board (source: Hanke 2002a: 94)

Argentinian economy after installing the currency board-like system. In the first years, until 1994, the new policy was very successful (cp. e.g. Grimm 2007: 44 et sqq.); the hyperinflation could be bound and the economy started growing. Even the Tequila Crisis in 1994[3] did not harm the positive development. After 1998, Argentina was again in economic decline which ended in an almost three year long recession.

[...]


[1] Physical currency, circulating in the economy and held within the central bank.

[2] This means, simply said, that it will extend credit if no one else will to prevent the financial collapse of a bank with liquidity problems. So domino effects to the economic system can be avoided.

[3] Popular name for the currency crisis in Mexico. The Mexican government could not hold the US $ peg of the Mexican peso what ended in capital flight and economy crisis.

Details

Pages
9
Year
2009
ISBN (eBook)
9783640335282
ISBN (Book)
9783640334964
File size
671 KB
Language
English
Catalog Number
v126833
Institution / College
Free University of Berlin
Grade
2,3
Tags
Argentinienkrise Currency Board Zentralbank IWF Dollar Peg Integrationstheorie Hyperinflation Argentinien

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Title: Currency Boards - How a Currency Board Works