A fully coherent post-Keynesian model of currency boards Marc Lavoie

1. A fully coherent post-Keynesian model of currency boards Marc Lavoie

2. Purpose of paper To present a post-Keynesian fully-coherent stock-flow model of an open economy led by a currency board. To demonstrate that, within a certain range, economies with currency boards behave roughly like those with central banks. To demonstrate that the compensation thesis applies to currency boards as well

3. Currency boards • Quick-fix solution to the problems of price and exchange rate instability. • ‘Pure’ currency boards hold a single type of asset – foreign reserves. • They provide no domestic credit: no advances to banks, no purchases of govt bills. • Any increase in the stock of HPM must be accompanied by an influx of foreign reserves, i.e., a favourable balance of payments. • Currency boards restore the Rules of the game (gold exchange standard). • A deficit in the balance of payments generate: • gold losses • reductions in the money supply and higher interest rates, • and lower activity • None of this is true in our PK stock-flow consistent currency board model. The only benefit may be credibility attributed by naïve markets!

4. The mainstream view of currency boards • “Under a currency board arrangement, the board normally agrees to supply or redeem domestic base money against a foreign currency without limit at a fixed exchange rate. Thus a pure currency board arrangement is essentially equivalent to a fixed exchange rate arrangement in which sterilization is prohibited and the monetary authorities have no autonomy over interest rates.” (Isard , Echange Rate Economics, Cambridge Surveys,1995)

5. There is an escape hatch in the currency board system, as in all monetary systems In Bulgaria , government deposits represent about 40% of the foreign exchange reserves which are to be found on the other side of the balance sheet of the currency board (Dobrev 1999). The government deposits play “the role of a buffer between changes in the monetary base and foreign exchange reserve dynamics .... Essentially it performs sterilizing functions and injects or withdraws liquidity in and out of the economy” (Nenovsky and Hristov 1998).

6. Hong Kong’s linked exchange rate • The Hong Kong dollar is tied to the US$ • Commercial banks issue banknotes • Commercial banks need to buy Certificates of Indebtness (CI) to do so, which they obtain by selling foreign currency to the currency board • Instead of CIs, they can obtain Exchange Fund paper (bills). • The Exchange Fund also holds assets denominated in Hong Kong dollars • The Exchange Fund also carries large government deposits

7. Hong Kong’s currency board: the linked exchange rate system

8. Foreign reserves are 7 times currency in circulation!

9. Currency boards set the target interest rate Despite the fact that there are no open-market operations, since these are prohibited by law, the currency board is able to set interest rates. The Bulgarian National Bank “announces the base interest rate”, whereas the standard belief is that under a currency board or more generally a fixed exchange rate, “the market alone should determine interest rates” (Dobrev 1999). The same applies to Hong Kong, although HMKA closely follows the federal funds target to set their own target overnight rate.

11. A fully consistent stock-flow open economy model, one with a currency board • In a model with free capital flows and imperfect asset substitution, it is quite simple to build a two-country model, where both the central bank of the North and the currency board of the South are able to set interest rates of their own.

12. Compensation mechanisms • In the central bank country, compensation operates through automatic sterilization, by moving government bills in and out of the assets of the central bank balance sheet. • In the currency board country, compensation operates through the acquisition or the disposition of government deposits.

14. CAB : current account balance KAB : capital account balance PSBR: public sector borrowing requirements (government deficit)

15. HG : government deposits; HH household cash; PG*OR ; gold reserves

16. Currency board vs central bank • Similarities • The currency board behaves no differently than a central bank under a regime of fixed exchange rates. • Monetary authorities set interest rates at the level of their choice. • The money supply is endogenous and demand-led. • Surpluses in the balance of payments do not create any excess money supply or excess liquidity in the monetary system. • The compensation thesis (open-economy reflux principle) rules. • The neoclassical Rules of the game do not hold.

17. Currency boards vs central banks • Differences • With a central bank, structural changes are needed when foreign reserves approach zero • With a currency board, structural changes are needed whenever foreign reserves fall below the cash money requirements of the private economy. • The currency board is committed to a fixed exchange rate, and can neither float nor change the parity of the domestic currency (unless under extraordinary circumstances, which may destabilize the currency board system).