A Theory of Currency Board with Irrevocable Commitments

Union De Creditos Inmobiliarios Working Paper

65 Pages Posted: 20 Feb 2002

See all articles by Nai-fu Chen

Nai-fu Chen

University of California, Irvine - Finance Area

Alex Chan

The University of Hong Kong, School of Economics and Finance

Date Written: February 12, 2002

Abstract

Currency boards are subject to runs if the foreign currency reserve is insufficient to back the convertible money supply. We construct a simple model capturing the main features of a currency board to analyze a government's decision to maintain or abandon a currency board based on the costs and benefits. Furthermore, we show how pre-specified commitments can enhance the credibility of a currency board and avert runs, and determine what the optimal reserve commitment should be. If there exists asymmetric information on the government's resolve, the government can use commitments as a costly signal to induce a separating equilibrium. The model can be adapted to analyze other hard-fixed exchange rate systems such as dollarizations and monetary unions. We illustrate the implications of our model in terms of the recent success in Hong Kong and remedies for Argentina.

Keywords: Currency board, Hong Kong, Argentina, irrevocable reserve commitment, put option, exchange rate insurance

JEL Classification: F310, E520

Suggested Citation

Chen, Nai-Fu and Chan, Wing-Ho Alex, A Theory of Currency Board with Irrevocable Commitments (February 12, 2002). Union De Creditos Inmobiliarios Working Paper, Available at SSRN: https://ssrn.com/abstract=300770 or http://dx.doi.org/10.2139/ssrn.300770

Nai-Fu Chen

University of California, Irvine - Finance Area ( email )

Irvine, CA 92697-3125
United States

Wing-Ho Alex Chan (Contact Author)

The University of Hong Kong, School of Economics and Finance ( email )

Pokfulam Road
Hong Kong
Hong Kong