A currency board system is an exchange rate regime in which the monetary authority explicitly commits to exchanging the domestic currency with specified foreign currency for a fixed exchange rate.
Three main characteristics distinguish this system from other exchange rates:
- The monetary authority explicitly states its commitment to keep the value of its currency with other countries’ currencies at a fixed price.
- Foreign exchange reserves must fully support each issuance of new currencies. That way, any change in foreign exchange reserves will equally change the money supply or base money. For example, if the rupiah reserve increases by 100 billion, to keep rupiah exchange rate against the dollar at 1 rupiah = 1 dollar, then foreign exchange reserves must also increase by 10 billion. That way, the exchange rate of the rupiah against the dollar is fixed.
- There is no policy on limiting foreign exchange reserves.
Expansion and contraction of base money are directly related to trade and capital flows. Trade and capital flows affect foreign exchange reserves. And, any changes in foreign exchange reserves will affect changes in the base money at an equal rate.
Increased money supply cannot be used to finance government budget deficits. However, that does not mean the government cannot run a fiscal deficit.
It is still possible for the government to run a deficit as long as the financing is through the issuance of government bonds.
The central bank cannot act as a last resort lender. That means the government or the central bank cannot help financial institutions when they experience financial difficulties. Therefore, the function of the central bank as a monetary controller is no longer needed.
When this system works best?
Not all countries are suitable for implementing this system. This system requires several conditions to work well. First, domestic prices and wages should be very flexible. Second, the traded economic sectors should make up the most significant component of domestic economic structure. Third, the global supply of reserve assets is growing at a slow and stable rate. The last, the successful implementation of this system, also requires the support of strict fiscal discipline.
Pros and cons
This system provides low and stable inflation. Fixed exchange rates allow the prices of imported products to be stable for domestic consumers.
But, only a few countries implement a currency board system. The reason, this system demands high credibility and discipline of fiscal policy from the government. Any indisciplined fiscal policy could result in a recession or economic downturn, as has happened in Argentina.
Furthermore, this system is also vulnerable to external pressure. When domestic goods become less competitive in the international market, it decreases foreign exchange reserves as exports fall. As a result, the base money (monetary basis or M0) also declines, which leads to an economic downturn or recession.