Discipline, Signaling, and Currency Boards

Abstract

The paper models the choice between currency boards (CBs) and adjustable pegs (or managed floating). Countries adopting CBs have grown faster and inflated less on average than countries adopting other regimes.The explanation hinges on key features of CBs: policy discipline and inflation credibility.The authors find separating equilibria in which a weak government chooses a CB as a discipline device while a tough government chooses a standard peg for its policy flexibility. Paradoxically, the weak government can then outperform the tough government on average. In simulations performed, CBs welfare can exceed peg welfare even when unemployment persistence is strong.

On the Credibility of Currency Boards*

“…A currency board is established by law, and leaving it requires a political process including preceding public discussion. While Oliva et al (2001) allow for a sudden exit out of the system in the second period, our paper captures that it is hardly possible to generate a surprise, as repealing a currency board takes time 4 . When Argentina finally left its currency board, this had been largely expected.…”

“…As Chang and Velasco consider opportunity costs of holding reserves, but do not model any possible disadvantages of flexible exchange rates, their conclusion that a flexible exchange rate is the optimal regime comes as no surprise. A different approach to capture the difference between a currency board and a standard peg is used by Oliva et al (2001), who analyze whether monetary authorities can signal their preferences on price stability by choosing between these two exchange rate systems. They emphasize that a currency board constitutes a long‐term commitment and assume that it can only be abolished in the second period of their two‐period model, whereas with a standard peg, a realignment in response to a supply shock is possible in either period.…”

“…In this paper, we take up the idea of Oliva et al (2001) that a currency board cannot be abolished overnight, but we model this feature more consequently. A currency board is established by law, and leaving it requires a political process including preceding public discussion.…”

The Stability of Currency Boards

“…Few other currency board crises models exist. Rivera Batiz and Sy (2000) and Oliva, Rivera Batiz, and Sy (2001) also use a second generation crises model approach. Instead of assuming a personal cost from devaluation, the policymaker's incentive to maintain the fixed exchange rate stems from the assumption that any devaluation must be of an arbitrarily fixed size, as in Drazen and Masson (1994, p. 738).…”

Currency boards, dollarized liabilities, and monetary policy credibility

“…In practice, this may reflect the fact that the costs of abandoning a currency board are decreasing over time. Without modeling the source of this development explicitly, we posit a framework similar to that used by Rivera-Batiz and Sy (1997) and Oliva et al (2001). We characterize a currency board as an exchange rate peg that can only be abandoned at a presumably large cost in the first period, but can be adjusted at no cost in the second period.…”