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Monetary policy
Finance

Monetary policy is the process by which the government, central bank, or monetary
authority of a country controls (i) the supply of money, (ii) availability of money, and (iii)
cost of money or rate of interest, in order to attain a set of objectives oriented towards the
growth and stability of the economy.[1] Monetary theory provides insight into how to craft
optimal monetary policy.

Monetary policy is referred to as either being an expansionary policy, or a contractionary

policy, where an expansionary policy increases the total supply of money in the economy,
and a contractionary policy decreases the total money supply. Expansionary policy is
traditionally used to combat unemployment in a recession by lowering interest rates, while
contractionary policy involves raising interest rates in order to combat inflation. Monetary
policy is contrasted with fiscal policy, which refers to government borrowing, spending and
taxation.[2]

[edit] Overview
Monetary policy rests on the relationship between the rates of interest in an economy, that is
the price at which money can be borrowed, and the total supply of money. Monetary policy
uses a variety of tools to control one or both of these, to influence outcomes like economic
growth, inflation, exchange rates with other currencies and unemployment. Where currency is
under a monopoly of issuance, or where there is a regulated system of issuing currency
through banks which are tied to a central bank, the monetary authority has the ability to alter
the money supply and thus influence the interest rate (in order to achieve policy goals). The
beginning of monetary policy as such comes from the late 19th century, where it was used to
maintain the gold standard.

A policy is referred to as contractionary if it reduces the size of the money supply or raises
the interest rate. An expansionary policy increases the size of the money supply, or decreases
the interest rate. Furthermore, monetary policies are described as follows: accommodative, if
the interest rate set by the central monetary authority is intended to create economic growth;
neutral, if it is intended neither to create growth nor combat inflation; or tight if intended to
reduce inflation.

There are several monetary policy tools available to achieve these ends: increasing interest
rates by fiat; reducing the monetary base; and increasing reserve requirements. All have the
effect of contracting the money supply; and, if reversed, expand the money supply. Since the
1970s, monetary policy has generally been formed separately from fiscal policy. Even prior
to the 1970s, the Bretton Woods system still ensured that most nations would form the two
policies separately.

Within almost all modern nations, special institutions (such as the Bank of England, the
European Central Bank, Reserve Bank of India, the Federal Reserve System in the United
States, the Bank of Japan, the Bank of Canada or the Reserve Bank of Australia) exist which
have the task of executing the monetary policy and often independently of the executive. In
general, these institutions are called central banks and often have other responsibilities such
as supervising the smooth operation of the financial system.

The primary tool of monetary policy is open market operations. This entails managing the
quantity of money in circulation through the buying and selling of various credit instruments,
foreign currencies or commodities. All of these purchases or sales result in more or less base
currency entering or leaving market circulation.

Usually, the short term goal of open market operations is to achieve a specific short term
interest rate target. In other instances, monetary policy might instead entail the targeting of a
specific exchange rate relative to some foreign currency or else relative to gold. For example,
in the case of the USA the Federal Reserve targets the federal funds rate, the rate at which
member banks lend to one another overnight; however, the monetary policy of China is to
target the exchange rate between the Chinese renminbi and a basket of foreign currencies.

The other primary means of conducting monetary policy include: (i) Discount window
lending (lender of last resort); (ii) Fractional deposit lending (changes in the reserve
requirement); (iii) Moral suasion (cajoling certain market players to achieve specified
outcomes); (iv) "Open mouth operations" (talking monetary policy with the market).

[edit] Theory

Monetary policy is the process by which the government, central bank, or monetary authority
of a country controls (i) the supply of money, (ii) availability of money, and (iii) cost of
money or rate of interest, in order to attain a set of objectives oriented towards the growth and
stability of the economy.[1] Monetary theory provides insight into how to craft optimal
monetary policy.

Monetary policy rests on the relationship between the rates of interest in an economy, that is
the price at which money can be borrowed, and the total supply of money. Monetary policy
uses a variety of tools to control one or both of these, to influence outcomes like economic
growth, inflation, exchange rates with other currencies and unemployment. Where currency is
under a monopoly of issuance, or where there is a regulated system of issuing currency
through banks which are tied to a central bank, the monetary authority has the ability to alter
the money supply and thus influence the interest rate (in order to achieve policy goals). The
beginning of monetary policy as such comes from the late 19th century, where it was used to
maintain the gold standard. A policy is referred to as contractionary if it reduces the size of
the money supply or raises the interest rate. An expansionary policy increases the size of the
money supply, or decreases the interest rate. Furthermore, monetary policies are described as
follows: accommodative, if the interest rate set by the central monetary authority is intended
to create economic growth; neutral, if it is intended neither to create growth nor combat
inflation; or tight if intended to reduce inflation.

It is important for policymakers to make credible announcements and degrade interest rates
as they are non-important and irrelevant in regarding to monetary policies. If private agents
(consumers and firms) believe that policymakers are committed to lowering inflation, they
will anticipate future prices to be lower than otherwise (how those expectations are formed is
an entirely different matter; compare for instance rational expectations with adaptive
expectations). If an employee expects prices to be high in the future, he or she will draw up a
wage contract with a high wage to match these prices. Hence, the expectation of lower wages
is reflected in wage-setting behavior between employees and employers (lower wages since
prices are expected to be lower) and since wages are in fact lower there is no demand pull
inflation because employees are receiving a smaller wage and there is no cost push inflation
because employers are paying out less in wages.

In order to achieve this low level of inflation, policymakers must have credible
announcements; that is, private agents must believe that these announcements will reflect
actual future policy. If an announcement about low-level inflation targets is made but not
believed by private agents, wage-setting will anticipate high-level inflation and so wages will
be higher and inflation will rise. A high wage will increase a consumer's demand (demand
pull inflation) and a firm's costs (cost push inflation), so inflation rises. Hence, if a
policymaker's announcements regarding monetary policy are not credible, policy will not
have the desired effect.

If policymakers believe that private agents anticipate low inflation, they have an incentive to
adopt an expansionist monetary policy (where the marginal benefit of increasing economic
output outweighs the marginal cost of inflation); however, assuming private agents have
rational expectations, they know that policymakers have this incentive. Hence, private agents
know that if they anticipate low inflation, an expansionist policy will be adopted that causes a
rise in inflation. Consequently, (unless policymakers can make their announcement of low
inflation credible), private agents expect high inflation. This anticipation is fulfilled through
adaptive expectation (wage-setting behavior);so, there is higher inflation (without the benefit
of increased output). Hence, unless credible announcements can be made, expansionary
monetary policy will fail.

Announcements can be made credible in various ways. One is to establish an independent

central bank with low inflation targets (but no output targets). Hence, private agents know
that inflation will be low because it is set by an independent body. Central banks can be given
incentives to meet their targets (for example, larger budgets, a wage bonus for the head of the
bank) in order to increase their reputation and signal a strong commitment to a policy goal.
Reputation is an important element in monetary policy implementation. But the idea of
reputation should not be confused with commitment. While a central bank might have a
favorable reputation due to good performance in conducting monetary policy, the same
central bank might not have chosen any particular form of commitment (such as targeting a
certain range for inflation). Reputation plays a crucial role in determining how much would
markets believe the announcement of a particular commitment to a policy goal but both
concepts should not be assimilated. Also, note that under rational expectations, it is not
necessary for the policymaker to have established its reputation through past policy actions;
as an example, the reputation of the head of the central bank might be derived entirely from
his or her ideology, professional background, public statements, etc. In fact it has been argued
(add citation to Kenneth Rogoff, 1985. "The Optimal Commitment to an Intermediate
Monetary Target" in 'Quarterly Journal of Economics' #100, pp. 1169-1189) that in order to
prevent some pathologies related to the time-inconsistency of monetary policy
implementation (in particular excessive inflation), the head of a central bank should have a
larger distaste for inflation than the rest of the economy on average. Hence the reputation of a
particular central bank is not necessary tied to past performance, but rather to particular
institutional arrangements that the markets can use to form inflation expectations. Despite the
frequent discussion of credibility as it relates to monetary policy, the exact meaning of
credibility is rarely defined. Such lack of clarity can serve to lead policy away from what is
believed to be the most beneficial. For example, capability to serve the public interest is one
definition of credibility often associated with central banks. The reliability with which a
central bank keeps its promises is also a common definition. While everyone most likely
agrees a central bank should not lie to the public, wide disagreement exists on how a central
bank can best serve the public interest. Therefore, lack of definition can lead people to
believe they are supporting one particular policy of credibility when they are really
supporting another.[3]

[edit] History of monetary policy

Monetary policy is primarily associated with interest rate and credit. For many centuries there
were only two forms of monetary policy: (i) Decisions about coinage; (ii) Decisions to print
paper money to create credit. Interest rates, while now thought of as part of monetary
authority, were not generally coordinated with the other forms of monetary policy during this
time. Monetary policy was seen as an executive decision, and was generally in the hands of
the authority with seigniorage, or the power to coin. With the advent of larger trading
networks came the ability to set the price between gold and silver, and the price of the local
currency to foreign currencies. This official price could be enforced by law, even if it varied
from the market price.

With the creation of the Bank of England in 1694, which acquired the responsibility to print
notes and back them with gold, the idea of monetary policy as independent of executive
action began to be established.[4] The goal of monetary policy was to maintain the value of the
coinage, print notes which would trade at par to specie, and prevent coins from leaving
circulation. The establishment of central banks by industrializing nations was associated then
with the desire to maintain the nation's peg to the gold standard, and to trade in a narrow band
with other gold-backed currencies. To accomplish this end, central banks as part of the gold
standard began setting the interest rates that they charged, both their own borrowers, and
other banks who required liquidity. The maintenance of a gold standard required almost
monthly adjustments of interest rates.

During the 1870-1920 period the industrialized nations set up central banking systems, with
one of the last being the Federal Reserve in 1913.[5] By this point the role of the central bank
as the "lender of last resort" was understood. It was also increasingly understood that interest
rates had an effect on the entire economy, in no small part because of the marginal revolution
in economics, which focused on how many more, or how many fewer, people would make a
decision based on a change in the economic trade-offs. It also became clear that there was a
business cycle, and economic theory began understanding the relationship of interest rates to
that cycle. (Nevertheless, steering a whole economy by influencing the interest rate has often
been described as trying to steer an oil tanker with a canoe paddle.) Research by Cass
Business School has also suggested that perhaps it is the central bank policies of
expansionary and contractionary policies that are causing the economic cycle; evidence can
be found by looking at the lack of cycles in economies before central banking policies
existed.

Monetarist macroeconomists have sometimes advocated simply increasing the monetary

supply at a low, constant rate, as the best way of maintaining low inflation and stable output
growth.[6] However, when U.S. Federal Reserve Chairman Paul Volcker tried this policy,
starting in October 1979, it was found to be impractical, because of the highly unstable
relationship between monetary aggregates and other macroeconomic variables.[7] Even Milton
Friedman acknowledged that money supply targeting was less successful than he had hoped,
in an interview with the Financial Times on June 7, 2003.[8][9][10] Therefore, monetary
decisions today take into account a wider range of factors, such as:

 short term interest rates;

 long term interest rates;
 velocity of money through the economy;
 exchange rates;
 credit quality;
 bonds and equities (corporate ownership and debt);
 government versus private sector spending/savings;
 international capital flows of money on large scales;
 financial derivatives such as options, swaps, futures contracts, etc.

A small but vocal group of people advocate for a return to the gold standard (the elimination
of the dollar's fiat currency status and even of the Federal Reserve Bank). Their argument is
basically that monetary policy is fraught with risk and these risks will result in drastic harm to
the populace should monetary policy fail. Others see another problem with our current
monetary policy. The problem for them is not that our money has nothing physical to define
its value, but that fractional reserve lending of that money as a debt to the recipient, rather
than a credit, causes all but a small proportion of society (including all governments) to be
perpetually in debt.

In fact, many economists disagree with returning to a gold standard. They argue that doing so
would drastically limit the money supply, and throw away 100 years of advancement in
monetary policy. The sometimes complex financial transactions that make big business
(especially international business) easier and safer would be much more difficult if not
impossible. Moreover, shifting risk to different people/companies that specialize in
monitoring and using risk can turn any financial risk into a known dollar amount and
therefore make business predictable and more profitable for everyone involved.

[edit] Trends in central banking

The central bank influences interest rates by expanding or contracting the monetary base,
which consists of currency in circulation and banks' reserves on deposit at the central bank.
The primary way that the central bank can affect the monetary base is by open market
operations or sales and purchases of second hand government debt, or by changing the
reserve requirements. If the central bank wishes to lower interest rates, it purchases
government debt, thereby increasing the amount of cash in circulation or crediting banks'
reserve accounts. Alternatively, it can lower the interest rate on discounts or overdrafts (loans
to banks secured by suitable collateral, specified by the central bank). If the interest rate on
such transactions is sufficiently low, commercial banks can borrow from the central bank to
meet reserve requirements and use the additional liquidity to expand their balance sheets,
increasing the credit available to the economy. Lowering reserve requirements has a similar
effect, freeing up funds for banks to increase loans or buy other profitable assets.

A central bank can only operate a truly independent monetary policy when the exchange rate
is floating.[11] If the exchange rate is pegged or managed in any way, the central bank will
have to purchase or sell foreign exchange. These transactions in foreign exchange will have
an effect on the monetary base analogous to open market purchases and sales of government
debt; if the central bank buys foreign exchange, the monetary base expands, and vice versa.
But even in the case of a pure floating exchange rate, central banks and monetary authorities
can at best "lean against the wind" in a world where capital is mobile.

Accordingly, the management of the exchange rate will influence domestic monetary
conditions. In order to maintain its monetary policy target, the central bank will have to
sterilize or offset its foreign exchange operations. For example, if a central bank buys foreign
exchange (to counteract appreciation of the exchange rate), base money will increase.
Therefore, to sterilize that increase, the central bank must also sell government debt to
contract the monetary base by an equal amount. It follows that turbulent activity in foreign
exchange markets can cause a central bank to lose control of domestic monetary policy when
it is also managing the exchange rate.

In the 1980s, many economists began to believe that making a nation's central bank
independent of the rest of executive government is the best way to ensure an optimal
monetary policy, and those central banks which did not have independence began to gain it.
This is to avoid overt manipulation of the tools of monetary policies to effect political goals,
such as re-electing the current government. Independence typically means that the members
of the committee which conducts monetary policy have long, fixed terms. Obviously, this is a
somewhat limited independence.

In the 1990s, central banks began adopting formal, public inflation targets with the goal of
making the outcomes, if not the process, of monetary policy more transparent. In other words,
a central bank may have an inflation target of 2% for a given year, and if inflation turns out to
be 5%, then the central bank will typically have to submit an explanation.

The Bank of England exemplifies both these trends. It became independent of government
through the Bank of England Act 1998 and adopted an inflation target of 2.5% RPI (now 2%
of CPI).

The debate rages on about whether monetary policy can smooth business cycles or not. A
central conjecture of Keynesian economics is that the central bank can stimulate aggregate
demand in the short run, because a significant number of prices in the economy are fixed in
the short run and firms will produce as many goods and services as are demanded (in the long
run, however, money is neutral, as in the neoclassical model). There is also the Austrian
school of economics, which includes Friedrich von Hayek and Ludwig von Mises's
arguments, but most economists fall into either the Keynesian or neoclassical camps on this
issue.

[edit] Developing countries

Developing countries may have problems establishing an effective operating monetary

policy. The primary difficulty is that few developing countries have deep markets in
government debt. The matter is further complicated by the difficulties in forecasting money
demand and fiscal pressure to levy the inflation tax by expanding the monetary base rapidly.
In general, the central banks in many developing countries have poor records in managing
monetary policy. This is often because the monetary authority in a developing country is not
independent of government, so good monetary policy takes a backseat to the political desires
of the government or are used to pursue other non-monetary goals. For this and other reasons,
developing countries that want to establish credible monetary policy may institute a currency
board or adopt dollarization. Such forms of monetary institutions thus essentially tie the
hands of the government from interference and, it is hoped, that such policies will import the
monetary policy of the anchor nation.

Recent attempts at liberalizing and reforming the financial markets (particularly the
recapitalization of banks and other financial institutions in Nigeria and elsewhere) are
gradually providing the latitude required in order to implement monetary policy frameworks
by the relevant central banks.

[edit] Types of monetary policy

In practice, all types of monetary policy involve modifying the amount of base currency (M0)
in circulation. This process of changing the liquidity of base currency through the open sales
and purchases of (government-issued) debt and credit instruments is called open market
operations.

Constant market transactions by the monetary authority modify the supply of currency and
this impacts other market variables such as short term interest rates and the exchange rate.

The distinction between the various types of monetary policy lies primarily with the set of
instruments and target variables that are used by the monetary authority to achieve their
goals.

Monetary Policy: Target Market Variable: Long Term Objective:

Interest rate on overnight
Inflation Targeting A given rate of change in the CPI
debt
Interest rate on overnight
Price Level Targeting A specific CPI number
debt
The growth in money
Monetary Aggregates A given rate of change in the CPI
supply
Fixed Exchange Rate The spot price of the The spot price of the currency
 currency
Low inflation as measured by the gold
Gold Standard The spot price of gold
price
Mixed Policy Usually interest rates Usually unemployment + CPI change

The different types of policy are also called monetary regimes, in parallel to exchange rate
regimes. A fixed exchange rate is also an exchange rate regime; The Gold standard results in
a relatively fixed regime towards the currency of other countries on the gold standard and a
floating regime towards those that are not. Targeting inflation, the price level or other
monetary aggregates implies floating exchange rate unless the management of the relevant
foreign currencies is tracking the exact same variables (such as a harmonized consumer price
index).

[edit] Inflation targeting

Main article: Inflation targeting

Under this policy approach the target is to keep inflation, under a particular definition such as
Consumer Price Index, within a desired range.

The inflation target is achieved through periodic adjustments to the Central Bank interest rate
target. The interest rate used is generally the interbank rate at which banks lend to each other
overnight for cash flow purposes. Depending on the country this particular interest rate might
be called the cash rate or something similar.

The interest rate target is maintained for a specific duration using open market operations.
Typically the duration that the interest rate target is kept constant will vary between months
and years. This interest rate target is usually reviewed on a monthly or quarterly basis by a
policy committee.

Changes to the interest rate target are made in response to various market indicators in an
attempt to forecast economic trends and in so doing keep the market on track towards
achieving the defined inflation target. For example, one simple method of inflation targeting
called the Taylor rule adjusts the interest rate in response to changes in the inflation rate and
the output gap. The rule was proposed by John B. Taylor of Stanford University.[12]

The inflation targeting approach to monetary policy approach was pioneered in New Zealand.
It is currently used in Australia, Canada, Chile, Colombia, the Eurozone, New Zealand,
Norway, Iceland, Philippines, Poland, Sweden, South Africa, Turkey, and the United
Kingdom.

[edit] Price level targeting

Price level targeting is similar to inflation targeting except that CPI growth in one year is
offset in subsequent years such that over time the price level on aggregate does not move.

Something similar to price level targeting was tried by Sweden in the 1930s, and seems to
have contributed to the relatively good performance of the Swedish economy during the
Great Depression. As of 2004, no country operates monetary policy based on a price level
target.

[edit] Monetary aggregates

In the 1980s, several countries used an approach based on a constant growth in the money
supply. This approach was refined to include different classes of money and credit (M0, M1
etc). In the USA this approach to monetary policy was discontinued with the selection of
Alan Greenspan as Fed Chairman.

This approach is also sometimes called monetarism.

While most monetary policy focuses on a price signal of one form or another, this approach is
focused on monetary quantities.

[edit] Fixed exchange rate

This policy is based on maintaining a fixed exchange rate with a foreign currency. There are
varying degrees of fixed exchange rates, which can be ranked in relation to how rigid the
fixed exchange rate is with the anchor nation.

Under a system of fiat fixed rates, the local government or monetary authority declares a
fixed exchange rate but does not actively buy or sell currency to maintain the rate. Instead,
the rate is enforced by non-convertibility measures (e.g. capital controls, import/export
licenses, etc.). In this case there is a black market exchange rate where the currency trades at
its market/unofficial rate.

Under a system of fixed-convertibility, currency is bought and sold by the central bank or
monetary authority on a daily basis to achieve the target exchange rate. This target rate may
be a fixed level or a fixed band within which the exchange rate may fluctuate until the
monetary authority intervenes to buy or sell as necessary to maintain the exchange rate within
the band. (In this case, the fixed exchange rate with a fixed level can be seen as a special case
of the fixed exchange rate with bands where the bands are set to zero.)

Under a system of fixed exchange rates maintained by a currency board every unit of local
currency must be backed by a unit of foreign currency (correcting for the exchange rate). This
ensures that the local monetary base does not inflate without being backed by hard currency
and eliminates any worries about a run on the local currency by those wishing to convert the
local currency to the hard (anchor) currency.

Under dollarization, foreign currency (usually the US dollar, hence the term "dollarization")
is used freely as the medium of exchange either exclusively or in parallel with local currency.
This outcome can come about because the local population has lost all faith in the local
currency, or it may also be a policy of the government (usually to rein in inflation and import
credible monetary policy).

These policies often abdicate monetary policy to the foreign monetary authority or
government as monetary policy in the pegging nation must align with monetary policy in the
anchor nation to maintain the exchange rate. The degree to which local monetary policy
becomes dependent on the anchor nation depends on factors such as capital mobility,
openness, credit channels and other economic factors.

See also: List of fixed currencies

[edit] Gold standard

Main article: Gold standard

The gold standard is a system in which the price of the national currency as measured in units
of gold bars and is kept constant by the daily buying and selling of base currency to other
countries and nationals. (i.e. open market operations, cf. above). The selling of gold is very
important for economic growth and stability.

The gold standard might be regarded as a special case of the "Fixed Exchange Rate" policy.
And the gold price might be regarded as a special type of "Commodity Price Index".

Today this type of monetary policy is not used anywhere in the world,[citation needed] although a
form of gold standard was used widely across the world prior to 1971. For details see the
Bretton Woods system. Its major advantages were simplicity and transparency.

[edit] Policy of various nations

 Australia - Inflation targeting

 Brazil - Inflation targeting
 Canada - Inflation targeting
 Chile - Inflation targeting
 China - Monetary targeting and targets a currency basket
 Eurozone - Inflation targeting
 Hong Kong - Currency board (fixed to US dollar)
 India - Inflation targeting
 New Zealand - Inflation targeting
 Norway - Inflation targeting
 Singapore - Exchange rate targeting
 South Africa - Inflation targeting
 Switzerland - Inflation targeting [13]
 Turkey - Inflation targeting
 United Kingdom[14] - Inflation targeting, alongside secondary targets on 'output and
employment'.
 United States[15] - Mixed policy (and since the 1980s it is well fitted/described by the
"Taylor rule" which shows that the Fed funds rate responds to shocks in inflation and
output)

Further information: Monetary policy of the USA

[edit] Monetary policy tools

[edit] Monetary base
Monetary policy can be implemented by changing the size of the monetary base. This
directly changes the total amount of money circulating in the economy. A central bank can
use open market operations to change the monetary base. The central bank would buy/sell
bonds in exchange for hard currency. When the central bank disburses/collects this hard
currency payment, it alters the amount of currency in the economy, thus altering the monetary
base.

[edit] Reserve requirements

The monetary authority exerts regulatory control over banks. Monetary policy can be
implemented by changing the proportion of total assets that banks must hold in reserve with
the central bank. Banks only maintain a small portion of their assets as cash available for
immediate withdrawal; the rest is invested in illiquid assets like mortgages and loans. By
changing the proportion of total assets to be held as liquid cash, the Federal Reserve changes
the availability of loanable funds. This acts as a change in the money supply. Central banks
typically do not change the reserve requirements often because it creates very volatile
changes in the money supply due to the lending multiplier.

[edit] Discount window lending

Many central banks or finance ministries have the authority to lend funds to financial
institutions within their country. By calling in existing loans or extending new loans, the
monetary authority can directly change the size of the money supply.

[edit] Interest rates

The contraction of the monetary supply can be achieved indirectly by increasing the nominal
interest rates. Monetary authorities in different nations have differing levels of control of
economy-wide interest rates. In the United States, the Federal Reserve can set the discount
rate, as well as achieve the desired Federal funds rate by open market operations. This rate
has significant effect on other market interest rates, but there is no perfect relationship. In the
United States open market operations are a relatively small part of the total volume in the
bond market. One cannot set independent targets for both the monetary base and the interest
rate because they are both modified by a single tool — open market operations; one must
choose which one to control.

In other nations, the monetary authority may be able to mandate specific interest rates on
loans, savings accounts or other financial assets. By raising the interest rate(s) under its
control, a monetary authority can contract the money supply, because higher interest rates
encourage savings and discourage borrowing. Both of these effects reduce the size of the
money supply.

[edit] Currency board

Main article: currency board

A currency board is a monetary arrangement which pegs the monetary base of a country to
that of an anchor nation. As such, it essentially operates as a hard fixed exchange rate,
whereby local currency in circulation is backed by foreign currency from the anchor nation at
a fixed rate. Thus, to grow the local monetary base an equivalent amount of foreign currency
must be held in reserves with the currency board. This limits the possibility for the local
monetary authority to inflate or pursue other objectives. The principal rationales behind a
currency board are three-fold:

1. To import monetary credibility of the anchor nation;

2. To maintain a fixed exchange rate with the anchor nation;
3. To establish credibility with the exchange rate (the currency board arrangement is the
hardest form of fixed exchange rates outside of dollarization).

In theory, it is possible that a country may peg the local currency to more than one foreign
currency; although, in practice this has never happened (and it would be a more complicated
to run than a simple single-currency currency board). A gold standard is a special case of a
currency board where the value of the national currency is linked to the value of gold instead
of a foreign currency.

The currency board in question will no longer issue fiat money but instead will only issue a
set number of units of local currency for each unit of foreign currency it has in its vault. The
surplus on the balance of payments of that country is reflected by higher deposits local banks
hold at the central bank as well as (initially) higher deposits of the (net) exporting firms at
their local banks. The growth of the domestic money supply can now be coupled to the
additional deposits of the banks at the central bank that equals additional hard foreign
exchange reserves in the hands of the central bank. The virtue of this system is that questions
of currency stability no longer apply. The drawbacks are that the country no longer has the
ability to set monetary policy according to other domestic considerations, and that the fixed
exchange rate will, to a large extent, also fix a country's terms of trade, irrespective of
economic differences between it and its trading partners.

Hong Kong operates a currency board, as does Bulgaria. Estonia established a currency board
pegged to the Deutschmark in 1992 after gaining independence, and this policy is seen as a
mainstay of that country's subsequent economic success (see Economy of Estonia for a
detailed description of the Estonian currency board). Argentina abandoned its currency board
in January 2002 after a severe recession. This emphasized the fact that currency boards are
not irrevocable, and hence may be abandoned in the face of speculation by foreign exchange
traders. Following the signing of the Dayton Peace Agreement in 1995, Bosnia and
Herzegovina established a currency board pegged to the Deutschmark (since 2002 replaced
by the Euro).

Currency boards have advantages for small, open economies which would find independent
monetary policy difficult to sustain. They can also form a credible commitment to low
inflation.