What is the difference between dollarization and currency board

When politicians print money without regard to the needs of the economy, the money can no longer be a store of value , since its value will be inflated away. Neither can it provide a unit of account, or pricing information, since prices could change daily, or even hourly.

Consequently, the local currency stops working as money — people stop using it for trade and seek other solutions. The solution to the credibility problem is to fix the exchange rate to a trusted foreign currency, called the reserve currency. There are 2 methods of fixing the exchange rate without the un-trusted central bank or government — currency boards and dollarization , where the people start using a foreign currency, which is often the United States dollar — hence, the name.

Because the exchange rate is fixed and cannot be varied, using a currency board or dollarization is called a hard currency peg. While some governments desire to have a fixed exchange rate , the main purpose of currency boards and dollarization is either to restore confidence in the domestic currency or to adopt another currency that can't be manipulated by local politicians. The fact that the exchange rate is fixed is merely a consequence of how currency boards and dollarization work.

If the only objective was to achieve a fixed exchange rate with a foreign currency, then the central bank can easily achieve this goal by acquiring the necessary reserves of the foreign currency and standing ready to exchange the foreign currency with the domestic currency in the desired ratio.

Whenever a country adopts fixed exchange rates, it gives up control of its own domestic monetary policy — a country cannot have an open market, and control both domestic interest rates and foreign exchange rates. A country can only control 2 of the 3; it cannot control all 3 factors simultaneously. Consequently, the macroeconomic cycles of the pegging country should follow those of the reserve country, since the central bank of the reserve country will adjust interest rates according to its own domestic monetary policy.

Or the pegging country should select the currency of a major trading partner, since changes in the value of the respective currencies can have a big impact on the pegging country.

For instance, both Denmark and Switzerland pegged their currency to the euro, because Europe was their major trading partner. Since they did not want to belong to the Eurozone, pegging their currency to the euro was the next best thing to facilitate trade. Denmark continues the peg, pegging the Danish krone to within 2. The Swiss stock market also quickly declined, reflecting the higher value of the franc.

Hence, during the late s, when several emerging markets in Asia pegged their currency to the United States dollar but traded mostly with Japan, their exports suffered when the dollar appreciated against the yen.

Sometimes, a basket peg , which is a peg to several currencies, can better serve the needs of the country. For instance, because many of the emerging countries in Southeast Asia trade with the United States, Europe, and Japan, it makes more sense for them to have a peg to the dollar, euro, and yen, as demonstrated by the Asian crisis, where Singapore, which has a basket peg, fared better than Hong Kong, which has a dollar peg.

With either dollarization or currency boards, interest rates must equal the reserve currency country's prevailing rates. With dollarization, unequal interest rates would cause investments to flow into or out of the country as it seeks higher returns. With currency boards, the interest paid on currency board notes must equal what can be earned on the reserve currency; otherwise, arbitrage will equalize the Interest rates, as investors borrow the cheaper currency to earn the higher interest of the other currency.

Because an economy suffers greatly without a domestic currency, a profligate government is eventually forced to try to reestablish credibility in the domestic currency. As we mentioned above, full dollarization creates positive investor sentiment, almost extinguishing speculative attacks on the local currency and the exchange rate.

The result is a more stable capital market, the end of sudden capital outflows , and a balance of payments that is less prone to crises. Last but not least, full dollarization can improve the global economy by allowing for easier integration of economies into the world's market.

Conclusion Many emerging economies already use dollarization to some extent or another. However, many have shied away from it because economies that would consider full dollarization are those that are still developing. For many countries, having an autonomous economic policy and the sense of individual statehood that comes with it is too much to give up for full dollarization, an extreme option that is for the most part irreversible. Actively scan device characteristics for identification.

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The currency board transmits that rate hike to the domestic economy, regardless of local conditions. If the country with a currency board is already in a recession , the rate hike could make it even worse. In a crisis, a currency board can cause even more damage. If investors offload their local currency quickly and at the same time, interest rates can rise fast.

That compromises the ability of banks to maintain legally required reserves and appropriate liquidity levels. Such a banking crisis can get worse fast because currency boards cannot act as a lender of last resort.

In the event of a banking panic , a currency board cannot lend money to banks in a meaningful way. Hong Kong has a currency board that maintains a fixed exchange rate between the U. While the currency board contributed to Hong Kong's trade with the U. Hong Kong Monetary Authority. Monetary Policy. Actively scan device characteristics for identification. Use precise geolocation data. Select personalised content.

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