[Joseph_E._Stiglitz,_Carl_E._Walsh]_Economics(Bookos.org) (1)

Under a currency board, the exchange rate between the local currency and,
say, the dollar is fixed by law. The central bank holds enough foreign currency to
back all the domestic currency and reserves it has issued. This precaution makes a
run on the currency unlikely—the central bank always has enough dollars to pay off
anyone who shows up wanting to exchange the domestic currency for dollars. Since
there is never any fear the country will run out of reserves, investors will have no
reason to panic and try to get their funds out before the pegged rate is abandoned.
Argentina operated with a currency board between 1991 and 2001. Because
Argentina had a history of high inflation, a currency board was viewed as a means
of establishing a credible, low-inflation environment by tying the Argentinean currency
to the U.S. dollar. The disadvantages of a currency board are two. First,
exchange rate adjustments can help ensure macroeconomic stability when two countries
face different economic disturbances. For example, a recession in Argentina
might be lessened by an exchange rate depreciation that spurs exports. A currency
board, like other fixed exchange rate systems, leaves countries unable to conduct
an independent monetary policy. If a country has a history of bad monetary policy,
however, such a limitation may be desirable. Second, under a currency board the
central bank cannot create reserves in the event of a domestic banking crisis—it
can no longer serve as the lender of last resort.
A more extreme solution to exchange rate volatility and currency crises is to
simply abandon the domestic currency and use the U.S. dollar, a policy called dollarization.
Ecuador dollarized in 2000; the Ecuadorian currency, the sucre, is no
longer used for transactions and all prices are quoted in U.S. dollars. By eliminating
the possiblity of exchange rate changes and tying itself to Federal Reserve
policy, it is argued, countries can benefit from the effects of reduced risk and lower
uncertainty. Like other fixed exchange rate systems, dollarization removes mone-
Ecuadorians read about their country’s switch to the U.S. dollar
as the official currency in 2000.
EXCHANGE RATE MANAGEMENT ∂ 773