Monetary policy within the framework of the currency board

Since the monetary reform of 1992, the realisation of Estonian monetary policy has followed the framework of the currency board; the currency board is a special arrangement in monetary policy realisation where unusually strict restrictions govern some significant operations conducted by the central bank.

In Estonia, such restrictions are stipulated in the Central Bank Act that safeguards the Estonian kroon. The law has two restraints on the realisation of monetary policy. The aim of the first is to secure the fixed exchange rate between the Estonian kroon and the Deutschmark (starting from 1999, automatically with the euro as well). The other restriction forbids the central bank from issuing uncovered money, i.e. its commitments (the cash in circulation and deposits kept in the central bank) must be covered by high-quality foreign currency reserves. Such foreign assets may, for example, be the foreign currency deposits in the reliable commercial banks in a developed country, or investments in the developed countries’ low-risk bonds.

The aim of such monetary policy strategy is to ‘import’ price stability by tying the exchange rate of the domestic currency with reliable foreign currency that is vital for the Estonian economy. The requirement to maintain a high level of foreign reserves comes from the necessity to secure the credibility of such a tie, without which the interest rate would stay unnecessarily high and would cause needless expenditure for the economy in pursuing the aims of the monetary policy.

According to the currency board’s restrictions, the direct realisation of monetary policy is based on operations on the currency market where the Bank of Estonia is compelled to buy or sell the kroon in compliance with the demands of the market, primarily for the Deutschmark and the euro. Other direct means of influence of the monetary policy have had either a limited significance, or have had only a brief impact when the function of the capital markets has been disrupted (e.g. in late 1997 when in order to achieve the credibility of the monetary system, the liquidity demands had to be tightened).

Due to the currency board’s high standard of ‘automatisation’ in the technology of monetary policy realisation, more importance has been given to the improvement of the efficiency of the monetary policy’s operational framework (i.e. updating the system of compulsory reserves, ensuring smooth currency movement between the central bank and financial sector, etc.), maintaining the stability of the financial sector and informing the public of the developments of the monetary policy environment and of the influence of economic policy.

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