The currency board is the ultimate form of a pegged exchange rate. Management of the exchange rate and the money supply is taken away from the nation’s central bank if it has one. Aside from a fixed exchange rate, a currency board is also mostly needed to maintain reserves of the underlying foreign currency.
In the currency board, the management of the exchange rate and money supply is provided to a monetary authority that decides about the valuation of a nation’s currency. Typically, this monetary authority as direct instructions to support all units of currency in circulation with foreign currency. Once foreign currency backed all domestic currency, it is known as a 100% reserve requirement. And with a 100% reserve requirement, a currency board runs similarly to a strong version of the gold standard.
Also, the currency board enables an unlimited exchange for the domestic currency for foreign currency. A conventional central bank can make money at will. However, a currency board needs to back additional units of currency with foreign currency. Now, as the currency board earns interest from foreign reserves, domestic interest rates often mimic the prevailing rates in the foreign currency.
Similar to most of the world’s large economies, the U.S. does not have a currency board. For the United States, the Federal Reserve is an actual central bank. And it operates as a lender of last resort. Also, the exchange rate can float and determined by market forces, as well as the Fed’s monetary policies.
Contrarily, currency boards are slightly limited in their power. Most of them just hold the required percentage of pegged currency that was last mandated. Also, they exchange local currency for the pegged or anchor currency. And this is usually the U.S. dollar or the euro.
Now, currency board regimes are typically praised for their relative stability and rule-based nature. Currency boards provide stable exchange rates, promoting trade and investment. And their discipline restricts government actions. Careless or irresponsible governments cannot directly print money to pay down deficits. This is where currency boards are known for keeping inflation under control.
And like everything else, currency boards have their downsides. In fixed exchange-rate systems, currency boards do not let the government set their interest rates. And that means economic conditions in a foreign country typically determine interest rates. The currency board imports most of that foreign country’s monetary policy by pegging the domestic currency to a foreign currency.