A Theory of Currency Board with Irrevocable Commitments

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