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Under a currency board system, money in circulation has to be 100% backed by foreign reserves. Suppose the domestic currency (A\$) is 100% backed by a foreign currency (B\$), with a fixed 1:1 ratio. If there is initially A\$100 in circulation, there will be B\$100 in foreign reserves.

Suppose all the money in circulation (A\$100) is deposited in a bank that has a 10% reserve requirement. The bank then lends out A\$90. Now, the money supply is A\$190, but the foreign reserve of the currency board is only B\$100, which is less than the 100% backing required.

In the presence of fractional reserve banking that increases the domestic money supply, how do currency boards ensure that the domestic currency remains 100% backed by foreign reserves? What is wrong with my understanding of currency board systems?

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  • $\begingroup$ Can you please back up your claim that "Under a currency board system, money in circulation has to be 100% backed by foreign reserves." Seems to me that the original definition is about banknotes and coins, not money in general. $\endgroup$
    – Giskard
    Aug 17, 2021 at 4:39
  • $\begingroup$ Not all money, just currency in circulation (proportionately small) plus reserve money (the money banks use to transact with each other and the "central bank"/currency board) must be 100% backed by foreign assets. $\endgroup$
    – BrsG
    Aug 17, 2021 at 8:39

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