A currency board is the organization within a country that carries out the activities to maintain a fixed currency exchange rate. It usually consists of part of a central bank or a related body. Most countries do not need a currency board as they operate a linked or floating exchange rate.
There are a variety of levels of control a country may seek to impose on the exchange rate between its currency and that of other countries. Many simply leave things entirely to the markets, an approach known as a floating rate. Occasionally, such countries may try to control the rate to mitigate a financial crisis, but will still operate a long-term policy of a floating rate. Some countries operate a linked rate in which the exchange rate is allowed to vary according to market behavior, but the government steps in if it moves outside of a particular range.
Other countries attempt to keep the exchange rate at a consistent level. In most cases, such countries will pick one particular foreign currency with which to fix, or peg, the exchange rate. This is often the United States dollar. Some countries may try to fix the rate against the average of several other currencies, though this can be more complicated to carry out.
It is possible to fix the exchange rate through legal means. This usually involves making it illegal to exchange domestic currency for foreign currency except through a government exchange, at which the rate is fixed. The level of political control needed to do this means such tactics are usually restricted to countries that are not major players on the global financial market.
The more common method of pursuing a fixed rate is to maintain a supply of cash in both domestic currency and the relevant foreign currency. This cash can be used to buy and sell on the currency markets. This buying and selling is designed to distort the market and correct any changes in price that would otherwise occur through free trade in the currencies. The currency board is responsible for carrying out this technique.
There are some significant restrictions on a currency board compared with a central bank in a country with a floating rate. The need to maintain convertibility between cash in domestic and foreign currencies means there is an inherent limit on the total amount of domestic currency in circulation. This rules out economic policies based on restricting or increasing the money supply. It also rules out a government printing extra money to fund its spending.
