IMF

A currency board combines three elements: a fixed exchange rate between a country’s currency and an “anchor currency,” automatic convertibility, and a long-term commitment to the system, often made explicit in the central bank law.

The main reason for countries to consider a currency board is to demonstrate that they are pursuing an anti-inflationary policy.A currency board is credible only if a country’s central bank holds sufficient official foreign exchange reserves to cover at least its entire monetary liabilities, thereby assuring financial markets and the public at large that every domestic-currency bill is backed by an equivalent amount of foreign currency in the official coffers.

Demand is higher for a “currency-board currency” than for currencies without guarantees because holders know that, rain or shine, their liquid money can easily be converted into a major foreign currency. Were it to come to such a testing of the system, its architects contend, automatic stabilizers would prevent any major outflows of foreign currency.

The mechanism works through changes in the money supply, which lead to interest rate changes, which, in turn, encourage funds to move between the domestic and the anchor currency. This is essentially the same mechanism that operates under a fixed exchange rate, but the exchange rate guarantee implied in the currency board rules ensures that the necessary interest rate changes and the attendant costs for the economy will be comparatively lower.

The obvious advantages of a currency board are economic credibility, low inflation, and low interest rates. But currency boards can prove limiting, especially for countries that have weak banking systems or are prone to economic shocks. With a currency board in place, the central bank can no longer serve as a lender of last resort for banks in trouble.

At most, it is limited to acting as an emergency fund that is either set aside at the time the currency board is introduced or funded, over time, out of central bank profits. Another disadvantage is that, with a currency board arrangement, it is not possible to use financial policies—that is, adjustments of domestic interest or exchange rates—to stimulate the economy. Instead, economic adjustment can be achieved only through wage and price adjustments, which can be both slower and more painful.