The currency board arrangement

The currency board arrangement left rather little room for possible choices of economic policy. From the very beginning of the reform, the flows of goods and services, but also of money and capital, were liberalised. One reason for an open economy is the small size of the domestic market (the Estonian population is 1.5 million). The economic decline and the low purchasing power of the population forced Estonian enterprises to export a large share of their production.

The undervalued kroon, as measured by purchasing power parity, contributes to lower production costs and stimulates foreign investment. The low cost of production factors, along with foreign direct investment in the form of technology and know-how, will in turn increase exports, which become the source of economic growth. The pegging of the Estonian kroon to the German mark (starting from 1 January 1999 to the Euro) guarantees the credibility of the currency and the overall stability of the economic environment.

Inflation in Estonia has been higher than in the EU, the main trading partner of the country, due to price adjustments, especially of non-tradable goods and services. If a fixed exchange rate arrangement is accompanied by inflation greater than that of the country’s trade partner, the real exchange rate will appreciate and that will increase the foreign trade deficit. That has also happened in Estonia but the surplus of services account and the inflow of foreign capital have balanced the foreign trade deficit.

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