Download A fully coherent post-Keynesian model of currency boards

A fully coherent post-Keynesian
model of currency boards
Marc Lavoie
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
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!
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)
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).
Hong Kong’s linked exchange rate
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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
Hong Kong’s currency board: the
linked exchange rate system
Balance sheet of the Currency Board Account, HKMA,
January 2004, billions of HK$
(Backing) Assets
Liabilities (Monetary base)
Foreign assets (all highlyliquid short-term securities)
360
Certificates of Indebtedness
145
Govt Currency
7
Bank reserves
55
Exchange Fund bills
123
Balance sheet of the Exchange Fund, HKMA,
January 2004, billions of HK$
Assets
Liabilities
Foreign assets 977
Domestic assets 97
Certificates of Indebtedness
145
Govt Currency
7
Bank reserves
Exchange Fund bills
55
123
Placements by banks
31
Govt deposits
277
Other liabilities
45
Net worth
Foreign reserves are 7 times currency in circulation!
345
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.
Table 1 : Balance sheet of the currency board model (Model CB)
South
Cash money
North
H’holds
Govt.
CBoard
H’holds
+ HhS
+ HgS
! HcbS
+ HhN
! BN
Bills
Bonds (issued
by North govt)
Bonds (issued
by South govt)
Govt.
+
xr$.pbLN .
BLhS N
+
pbLS .BLhS
.xr +
pbLN .BLhN
C. Bank
E
! HhN
0
+ BcbN
0
!
pbLN.BLN
0
N
!
pbLS .BLS
.xr +
pbLS .BLhN
S.xr
S
Gold reserves
+ orS.pgS
.xr
Wealth
! VhS
! VgS
0
.xr ! VhN
E
0
0
0
0
0
+
orN.pgN
orN.pgN. +
orS.pgS.xr
! VgN
0
!
(orN.pgN+
orS.pgS.xr )
0
0
0
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.
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.

Chart 2: South's import propensity rises:
effect on income of both countries
101
100
99
98
97
96
95
YN
YS
Chart 3: South's import propensity rises:
effect on key balances
0,6
0,4
0,2
0
-0,2
-0,4
-0,6
-0,8
-1
CAB : current account balance
KAB : capital account balance
PSBR: public sector borrowing requirements (government deficit)
CABs
KABs
PSBRs
Chart 4: South's import propensity rises:
effects on South's CB balance sheet components
70
50
30
10
-10
HGs
HG : government deposits;
HHs
HH household cash;
PGs*O Rs
PG*OR ; gold reserves
Currency board vs central bank
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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.
Currency boards vs central banks
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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).