Model Answer
0 min readIntroduction
In an increasingly interconnected global economy, nations often seek to bolster economic stability and credibility through fixed exchange rate regimes. Two prominent approaches are the Currency Board Arrangement (CBA) and Dollarisation, both aiming to reduce inflation and enhance investor confidence. While both involve pegging the domestic currency to a foreign currency, typically the US dollar, they differ significantly in their implementation and implications for monetary policy. Recent examples like Argentina’s consideration of dollarisation (2023) and historical implementations of CBAs demonstrate the relevance of understanding these arrangements.
Currency Board Arrangement (CBA)
A Currency Board Arrangement is a monetary authority that is legally committed to exchanging domestic currency for a specified foreign currency at a fixed exchange rate. Crucially, the CBA holds foreign reserves equal to 100% (or more) of the domestic currency in circulation. This means every unit of domestic currency must be backed by an equivalent unit of the foreign reserve currency. The primary goal is to maintain exchange rate stability and control inflation.
- Monetary Policy: Limited monetary policy independence. The CBA cannot create money independently; it can only issue domestic currency when it receives foreign reserves.
- Lender of Last Resort: Typically, a CBA does not act as a lender of last resort to banks, increasing financial sector vulnerability.
- Flexibility: Offers some flexibility as the domestic currency still exists, allowing for seigniorage revenue (though limited).
Dollarisation
Dollarisation involves a country unilaterally adopting the currency of another nation, typically the US dollar, as its legal tender. This means completely abandoning the domestic currency. It represents a more complete form of exchange rate commitment than a CBA.
- Monetary Policy: Complete loss of monetary policy independence. The country adopts the monetary policy of the currency issuer (e.g., the US Federal Reserve).
- Lender of Last Resort: No independent lender of last resort function.
- Flexibility: No flexibility in exchange rate or monetary policy.
Distinguishing Features: A Comparative Table
| Feature | Currency Board Arrangement | Dollarisation |
|---|---|---|
| Domestic Currency | Retained | Abandoned |
| Reserve Coverage | 100% (or more) | Not Applicable |
| Monetary Policy Independence | Limited | None |
| Lender of Last Resort | Generally Absent | Absent |
| Seigniorage | Limited Revenue | No Revenue |
Why Choose One Over the Other?
A nation might adopt a Currency Board Arrangement when it seeks to quickly restore credibility and control hyperinflation, while retaining some degree of national identity and seigniorage. It’s often seen as an intermediate step towards full dollarisation. Hong Kong’s linked exchange rate system (a form of CBA) is a prime example. However, the lack of a lender of last resort can be a significant drawback.
Dollarisation is typically considered by countries facing severe and persistent economic crises, where a complete loss of monetary sovereignty is deemed a worthwhile price to pay for price stability and access to a credible currency. Ecuador adopted the US dollar in 2000 following a severe banking crisis and hyperinflation. The benefits include eliminating exchange rate risk and potentially lowering interest rates. However, it forfeits the ability to respond to asymmetric shocks (shocks that affect the country differently than the currency issuer).
The choice depends on the specific circumstances of the country, including the severity of its economic problems, its political constraints, and its willingness to relinquish monetary policy control. Countries with strong institutions and a history of sound economic management may be more comfortable with a CBA, while those with deeply entrenched instability may opt for the more radical step of dollarisation.
Conclusion
Both Currency Board Arrangements and Dollarisation represent attempts to import monetary credibility and stability. While a CBA offers a degree of flexibility, dollarisation provides a more definitive break from past monetary mismanagement. The decision to adopt either arrangement is a complex one, involving a trade-off between monetary sovereignty and economic stability. Ultimately, the success of either approach hinges on sound fiscal policies and structural reforms to address the underlying causes of economic instability.
Answer Length
This is a comprehensive model answer for learning purposes and may exceed the word limit. In the exam, always adhere to the prescribed word count.