A modified currency board system: Theory and evidence

The modified currency board (MCB) with a preference for both its credibility and economic growth can exercise limited discretionary power to maintain a substitution relationship between the credit instrument and exchange rate instrument. Under the assumption that money demand is more sensitive to credit expansion than money supply, the MCB's response function takes the credit instrument for growth as the world interest rate falls but the exchange rate instrument instead as the world interest rate rises. The survival of a MCB depends both on the nature of a shock and on its preference for credibility versus growth. This paper's finding suggests that the recent collapse of Argentina's currency board system as well as macroeconomic hardship in Hong Kong may stem from a combination of the falling world interest rate and a rigid credibility-oriented currency board.