In most countries, the management of currency—the issue and redemption of notes and coins—is bundled with other monetary tasks of the central bank. Undertaking these tasks gives the central bank flexibility and discretion but can also breed uncertainty about its basic objectives. The associated policy trade-offs may reflect political pressures on top of the usual considerations of monetary stability. The diversity of public interests sends confusing signals to the central bank, and the complexity of monetary outcomes and their potential causes sends similarly confusing signals to the public. Moreover, the “time inconsistency” of optimal policies (Kydland and Prescott (1977); Barro and Gordon (1983); Blackburn and Christensen (1989)) may undermine the central bank’s credibility. For these reasons, many economists have advocated narrowing central bank mandates—for example, to focus only on monetary stability instead of some combination of objectives regarding inflation, real growth, and employment. Some recommendations also reduce a central bank’s flexibility by committing it to achieving a predetermined rate of money supply growth or inflation.
One way to narrow a central bank’s mandate is to delegate the issuance and redemption of currency to a separate institution, which we call an “independent currency authority,” or ICA. For example, an ICA might issue domestic currency that is convertible into a specified foreign currency at a fixed exchange rate and back up this commitment by holding a foreign reserve cover equal to 100 percent of the currency issue. Such an ICA is known as a currency board, and the prefix “orthodox” is sometimes added to distinguish it from other variants.
Other ICA arrangements might include those under which the currency authority, although not formally independent of the central bank, nevertheless operates autonomously. Estonia, for example, has recently opted for a currency board in which the outstanding stock of high-powered money is fully backed by foreign reserves and legally convertible into deutsche marks at a fixed rate. Those functions of a central bank that are not delegated to an ICA have been handled in a variety of ways. In countries with orthodox currency boards, free banking has tended to prevail.1 In Estonia, the non-ICA functions of the Bank of Estonia, such as emergency lending to commercial banks and bank supervision and licensing, are operated by separate departments.
This paper considers how ICAs operate and describes their attractions as well as the constraints they impose on the banking system and on the government’s fiscal position. The first section outlines the operating principles of an ICA. We show that in order to maintain confidence in the currency, an ICA must exchange the domestic currency on demand, according to a preannounced exchange rate schedule against a standardized commodity or foreign currency, and must maintain full or close-to-full reserve cover. Thus, to a certain degree, price stability and convertibility are built into an ICA. A second section examines the fiscal implications of ICAs, while a third section considers banking arrangements and shows that an ICA may require extra banking discipline.
Barro, Robert J., and David Gordon, “Rules, Discretion, and Reputation in a Model of Monetary Policy,” Journal of Monetary Economics 12 (July 1983), pp. 101–21.
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Orthodox currency boards were once widespread in the colonial regimes of Africa, Asia, and the Caribbean, but now operate only in Hong Kong and Brunei. For a comprehensive history of currency boards, see Schuler (1992), Hanke and Schuler (1991a, 1991b, 1991c), and Shannon (1951, 1952). Schuler (1992) documents the relative success of currency boards in promoting price stability, foreign trade, and saving and investment. Although some economists view currency boards as anachronistic, others defend them as a relatively easy way to achieve monetary stability and convertibility (Greenwood (1984); Walters (1987); Hanke and Schuler (1991b)). Recently, they have been advocated for the emerging market economies in Eastern Europe and the former Soviet Union (Hanke and Schuler (1991a, 1991b); Walters (1992)).
The ICA might also use a basket of commodities or foreign currencies as the exchange standard. Such a standard would be more complicated to administer and less transparent to the public, but not unmanageable.
The latter had the advantage of being cheaper to transport and hold than gold.
The ICA may affect the relative priority of monetary stability and convertibility through its choice of a reserve currency anchor. Control over inflation is most easily achieved with a very stable currency as the reserve anchor, although convertibility considerations favor using the currency (or currency basket) of the main trading and investment partner(s).
Revenue from seigniorage refers to the difference between the interest earnings from the investment of foreign reserves and the ICA’s administrative expenses, including costs of printing bank notes and minting coins, at a stable price level.
The foreign country might agree to share seigniorage, but it is not easy to monitor changes in currency holdings in different regions of a common currency zone, to calculate an appropriate sharing ratio, or to enforce a sharing agreement. In practice, there would seem to be a tendency to treat imputed seigniorage as simply a form of delivering an independently determined amount of aid.
As already noted, an orthodox currency board generates seigniorage. In addition, a currency board that operates a depreciating peg would also generate inflation tax revenue. In the case where the rate of depreciation is gradually reduced to zero as the domestic inflation rate converges on that of the reserve currency country, the inflation tax revenue would correspondingly decline, but the seigniorage receipts would continue. By contrast, the ability of a discretionary central bank to inflict inflation surprises allows it to generate extra revenue from the inflation tax quickly. But to the extent that monetary policies are anticipated by money holders, the revenue gain associated with a shift from a depreciating-peg currency board to a central bank pursuing the same peg is unlikely to be large. With incomplete anticipation, the additional inflation tax generated by a central bank will be offset by the credibility and uncertainty costs. Hence, for a given average inflation rate, the central bank may be able to generate more inflation tax than an ICA. For a given degree of price predictability, the seigniorage advantage goes to an orthodox ICA. A more detailed note on the impact of monetary institutions on revenues from seigniorage and the inflation tax is available from the authors on request.
If civil servants and pensioners expect inflationary shocks, they may press for formal indexation to prevent even a temporary drop in real incomes. Failing that, they will attempt to negotiate a wage or pension buffer against potential future inflation shocks.