“Even if we only have eight Kroons in circulation, we will have a D-Mark in our vaults to back them” (Siim Kallas, President of the Estonian Central Bank, upon launching the currency board).
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Policy Development and Review Department; Monetary and Exchange Affairs Department; New York University, Princeton University, and NBER, respectively. We would like to thank Kadima Kalonji for his assistance, as well as Helge Berger, Hugh Bredenkamp, Charles Enoch, Paul Masson, Steven Phillips, Christopher Ryan, Jeffrey Sachs and seminar participants at Georgetown University for helpful comments.
The first British currency board (CB) arrangement was Mauritius in 1849. For historical analysis and descriptions, see Collyns (1983), Hanke and Schuler (1991), Schwartz (1993) and Williamson (1995). Somalia and the Philippines operated under CB arrangements under Italian and US administration respectively, while most French colonies had a weaker arrangement with partial backing in domestic assets.
Balino, Enoch, Ize, Santiprabhob and Stella (1997) provide a recent analytical survey.
The bibliography contains references to the individual country experiences.
It is sometimes argued that adopting a currency board entails forgoing seignorage revenues. This is incorrect since the central bank continues to earn interest on its foreign assets, while paying none on most of its domestic liabilities (mainly base money). Moreover, a central bank with a pegged exchange rate will also be limited in its ability to expand domestic credit, at least if it wants to sustain the peg for long. Thus seignorage arguments are largely irrelevant in any comparison within the set of pegged exchange rate systems.
It is worth emphasizing that it is economic, not geographic or population size which matters in this respect.
Foreign branch banking was a common feature of most colonial CB systems, perhaps contributing to their durability.
Osband and Villanueva (1992), Schwartz (1993), Bennett (1994) and Williamson (1995) provide more detailed discussions of the advantages and disadvantages of currency boards. Fischer (1992) and Eichengreen (1994) provide alternative views on the case for national moneys and the sustainability of fixed exchange rates.
The literature to date has not yet provided a clear answer regarding the “best” inflation rate. In this paper we will thus focus on the deviation from zero, rather than the deviation from some optimal rate.
While the group of currency board countries does include a number of small economies (with population ranging from 0.1 million inhabitants for St. Vincent and the Grenadines to 35 million for Argentina), our principal results are not attributable to this factor. In regressions restricting the sample to include only countries with 5 million inhabitants or fewer, the results for inflation remain highly significant. The results for growth, while pointing into the same direction, lose their statistical significance in the full regression with all explanatory variables included.
In particular, this means that countries within the CFA zone are excluded, since the CFA requires only 20 percent cover and has other features, including access to automatic overdraft with the French treasury, which make it rather different from the currency boards considered here. A reclassification (i.e. their inclusion in the currency board sample) of the CFA countries—which account for about 15 percent of observations in the group of pegged exchange rates—would not, however, alter our basic findings below that currency boards are associated with lower inflation. It would, however, reduce the average GDP growth rate of the currency board sample to (slightly) below the average of pegged exchange rate regimes.
Corresponding results for the breakdowns by per capita income level, and the absence of capital controls, are given in the first row of the succeeding blocks.
The money demand function simply provides a convenient analytical framework for discussing the results. It bears emphasizing, however, that none of the results depends upon the adoption of a particular form of the money demand function.
These changes could, theoretically also reflect financial deepening and financial innovation. However, as is shown below, this effect is significantly larger under currency board regimes. As there is no reason to assume a higher degree of financial sector innovation under this regime, it seems natural to interpret ∆v as “confidence” in the domestic currency.
Essentially, the coefficient is subject to an “omitted variable bias,” but this bias is precisely the effect of money growth on inflation, weighted by the correlation between the exchange rate regime and the rate of money growth, i.e., the discipline effect.
The coefficients on the central banker turnover rate is 0.05 (t-statistic: 2.57**) and on GDP growth is -0.21 (t-statistic: 3.79**). Thus lower central bank independence is associated with higher inflation, while higher GDP growth is associated with greater money demand and lower inflation, in accordance with (2). The openness variable is insignificant.
On theoretical grounds, the case for greater credibility is ambiguous as a system with well-designed escape clauses may dominate a currency board system, which may result in extreme obstacles to adjustment (Persson and Tabellini (1990)).
where j is a matrix of l’s and 0’s such that XJ=X1.
The central bank independence variables are assumed to be constant beyond 1990 where the data do not exist. The definition of capital controls follows the IMF’s Annual Report on Exchange Arrangements and Exchange Restrictions (AREAER).
Some of the variables in this regression, such as the investment ratio, might themselves be
affected by the choice of the exchange rate regime.
The standard deviation of GDP growth under currency boards is about 0.7 percentage
points lower than under other pegged exchange rate regimes.