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Article Excerpt
Abstract
Is it preferable for a modified currency board (MCB) to disguise its true characteristics and preferences and renege later? This paper analyzes a model in which a MCB determines its first-period exchange rate strategy to maximize a two-period welfare function. The inflation rate anchored by a classical currency board (CCB) is always a benchmark to the MCB in its first period decision. If the benchmark inflation rate is either sufficiently low or sufficiently high, the MCB chooses the optimal exchange rate in both periods without playing a credibility game over time. However, if the benchmark is at a moderate level, a strategy of overtly deceiving the public by pretending to be a CCB is shown to be superior to a strategy of concealing through policy randomization. (JEL E42, F32, F41)
Introduction
The orthodox or classical currency board (CCB) represents a stringent policy rule characterized by a 100% foreign reserve backing of the monetary base and the full convertibility between the domestic currency and the anchor (reserve) currency at a fixed official exchange rate. The CCB establishes and maintains its credibility and, thus, eliminates the public's inflationary expectations by precluding itself from discounting domestic assets (see Hanke et al. [1993] and Balino and Enoch [1997] for overviews of the currency-board theories and practices). Nevertheless, the currency board systems in today's world are more or less differently structured from its pure type. While they share some fundamental common features, such as about 100% convertibility undertaking between the domestic currency and the reserve currency (or assets payable in the reserve currency), there are indeed many variations in respect of actual arrangements; in particular, the domestic circumstances have been important in shaping each of the systems now in practice.
Although the practice of CCB, as a transparent and binding rule, relinquishes the monetary authority's ability to determine the money supply and the exchange rate and, therefore, avoids, or at least mitigates, the possibility of dynamic inconsistence, it is difficult after all to consider all the contingencies into the preset policy rules; hence, the policy credibility needed to control inflation could be in conflict with the policy flexibility in dealing with various economic shocks. Especially, the loss of monetary policy autonomy whether to finance a budget deficit, rescue banks, or boost aggregate demand is exactly the price a currency board economy pays for putting inflation under control [Obstfeld and Taylor, 1998; Ghosh et al. 1998; Rodrik, 2000]. The inherent tradeoff between credibility and flexibility has yielded the practice of modified currency board (MCB). Under the MCB, the main advantage for a limited extent of exchange rate flexibility and monetary liquidity is to avoid the structural rigidity (price and wage rigidity, for example) that a pure currency board faces in combating large current account deficits, capital flight, and domestic unemployment, though their drawbacks are adverse impacts on the credibility of the currency board. Indeed, it is often a country-specific issue how far a currency board should go toward relaxing its discretionary power over exchange rates and domestic credit.
In spite of the existing practices of MCB, it is unfortunate that very few studies in the existing literature have attempted to explore formally variants of the CCB. Wu [2005] models a MCB that has two confined discretions: a moderate degree of flexibility in the domestic credit and a moderate degree of flexibility in exchange-rate variations, and shows that the two policy instruments optimally maintain a substitution relationship. It is also shown and tested with the data of Argentina and Hong Kong that the survival of such a MCB depends both on the nature of economic shocks and on the MCB's preference for credibility vs. growth. The question that is not answered in Wu [2005], however, is a dynamic one, concerning whether it is preferable for the MCB to invest in its low-inflation credibility over time at the expense of real benefits from output and employment and when and how the MCB considers to deviate from the path of a CCB.
Attempting to tackle these issues, the present paper is mainly motivated by the following two considerations. First, theoretically, time inconsistency can arise from discretionary policy [Kydland and Prescott, 1977; Barro and Gordon, 1983; Backus and Driffill, 1985; Barro, 1986] or a rule that allows constrained discretion (see Bernanke and Mishkin [1997] on inflation targeting) or even a rule that does not formally allow discretion even if it in fact exists [Enoch and Gulde, 1997]. Although the currency board as a rule-bound regime is not supposed to be flexible by its nature, it is not, after all, completely immune from the problem of time inconsistency since moral hazard remains with policymakers at times, even if any flexibility in this context is substantially confined and repressed. As a currency board arrangement is not just a legal matter but also an operational matter, stringent restrictiveness by ensuring strong discipline on the system could jeopardize its credibility while seemingly strengthening it.
Second, practically, time inconsistency has existed in the real-world currency boards, many of which have departed from the 'orthodox' model one way or another to adapt to the changing economic environment. Take three examples: Argentina, Hong Kong, and Bulgaria. Argentina's currency board can serve as a lender of last resort by issuing money to a level beyond what...
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