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General principles of the Estonian monetary system
 The primary objective of Eesti Pank is to ensure price
stability by means of a stable exchange rate.
The Estonian monetary system is based on a currency board
arrangement, under which the exchange rate of the Estonian kroon is pegged to the euro.
In order to maintain the fixed rate of the Estonian kroon,
the central bank's liabilities, including the monetary base in the economy, must be fully guaranteed by foreign exchange reserves.
The primary objective of Eesti Pank is to ensure price stability by means of a stable exchange rate. Estonia manages
the exchange rate by applying the principles of a currency board arrangement,
according to which the rate of the Estonian kroon is pegged to the euro (1 euro = 15.6466 kroons)[1].
The Estonian kroon is freely convertible; i.e., there are no restrictions to the free movement of capital.
Estonia has applied the currency board arrangement since 1992. A currency board is an automatic system based on
stringent rules. In order to maintain the fixed rate of the Estonian kroon, the central bank's liabilities, including the monetary base
in the economy, must be fully guaranteed by gold or foreign exchange reserves.
Eesti Pank operates independently from other state authorities. Under the currency board arrangement, the central bank is prohibited by law to directly or indirectly credit the
central government and local governments. According to the Law on the Security of the Estonian Kroon, Eesti Pank has no right to devaluate
the exchange rate of the kroon.
The central bank has monetary policy instruments at its disposal for
ensuring the smooth functioning of the currency board arrangement. These instruments are used to ensure the smooth functioning of the
liquidity system and provide sufficient buffers to cope with any contingency. The forex window and the reserve requirement for banks are
the main instruments of monetary policy. Under the currency board framework, the reserve requirement ratio is considerably higher in
Estonia (currently 15% of the reserves) compared to countries employing other exchange rate systems.
Transactions in the forex window determine the monetary base or money supply in the economy. As money supply changes,
an equivalent change occurs in the central bank's foreign exchange reserves. Thus, Eesti Pank does not pursue an active monetary policy.
This means that the central bank does not establish interest rates or otherwise manage the money supply. Under the currency board
arrangement, Eesti Pank can theoretically lend money to credit institutions only from reserves in excess of the assets covering the kroon.
Since monetary policy instruments are limited in a fixed exchange rate system, the Government's fiscal policy plays an
essential role in stabilising the Estonian economy. A conservative and balancing budgetary policy is thus vital to ensuring the
sustainability of the economy. Flexibility of the non-financial sector, especially the labour market, is another important prerequisite to
the smooth functioning of the currency board arrangement. As the exchange rate is fixed, the economy cannot be balanced by exchange rate
changes. Therefore, economic growth has to adjust on the side of the non-financial sector - in wages and prices.
[1] The current exchange rate is equivalent to the exchange rate of the
Estonian kroon to the German mark (1 mark = 8 kroons), which was established by the monetary reform of 1992.
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