Question

What does it mean when one currency is "pegged" against another currency? Why do countries peg their currencies? What problems can result from pegging?

Short answer

Currency pegging is essentially fixing an exchange rate to another country's currency or the price of gold, with the aim of stabilizing the exchange rate. Countries peg their currencies primarily for economic stability and to facilitate trade and investment. But crucial problems can arise, such as loss of monetary policy independence and the potential for overvaluation or undervaluation of the pegged currency, leading to potential account imbalances and social unrest.

Step-by-step solution

Understanding Currency Pegging

Currency pegging refers to a country's practice of fixing its exchange rate to another country's currency or the price of gold. The purpose of this scheme is to stabilize the exchange rate. In a pegged regime, the country's central bank uses its foreign exchange reserves to buy or sell foreign currency in the market to balance supply and demand, thereby maintaining a fixed exchange rate.

Reasons for Currency Pegging

Countries peg their currencies for several reasons. One of the main motives is to stabilize the exchange rate, reducing the risk of exchange rate fluctuations, and therefore facilitating trade and investment. It can also be done to stabilize a country’s economy, especially for those with weak or under-developed financial systems, or to prevent inflation, as it forces the country to follow the fiscal and monetary policies of the country to whose currency it is pegged.

Problems from Pegging Currencies

Despite the aforementioned benefits, currency pegging can bring about problems. Currency pegging can reduce a country's monetary policy independence, as it must follow the fiscal and monetary policies of the country to which it’s pegged. If the pegged currency becomes overvalued, this can lead to a balance of payments deficit. On the other hand, if it becomes undervalued, it may lead to inflation and social unrest. Currency pegging can be hard to maintain, especially in a downturn, leading to depletion of the country's foreign exchange reserves.

Key concepts

Exchange Rate Stability

Exchange rate stability refers to the consistent value of a country's currency in relation to another currency or a basket of currencies. When a currency is stable, it means it does not fluctuate wildly in value, making it predictable. This predictability is crucial for international businesses as it allows for smooth trade and investment activities across national borders.

One of the main reasons countries strive for exchange rate stability is to limit the economic uncertainty that can result from fluctuating exchange rates. Such fluctuations can affect the cost of imported goods and services, potentially impacting domestic prices and inflation.

• Predictable exchange rates reduce the risk for exporters and importers.
• It helps in attracting foreign investment as investors prefer stability.
• It minimizes the inflationary effects of currency devaluation.

However, achieving and maintaining exchange rate stability requires active intervention by a country's central bank, often through currency pegging, where a country fixes its exchange rate to another stable currency or a basket of currencies.

Monetary Policy

Monetary policy refers to the actions undertaken by a nation's central bank to control money supply, interest rates, and achieve macroeconomic objectives such as controlling inflation, consumption, growth, and liquidity.

In the context of currency pegging, monetary policy takes on a significant role, as a country aligning its currency with another must often relinquish some control over its own monetary policies. This means following the fiscal and monetary policies of the reference country, which can limit the flexibility needed to address domestic economic issues.

• A pegged currency restricts the central bank's ability to adjust interest rates independently.
• The central bank might need to hold or increase foreign currency reserves to support the peg.
• It often leads to a trade-off between exchange rate stability and economic growth.

Despite these challenges, countries often choose pegged systems to enforce discipline on their monetary policies, hoping that the stability brought by the peg compensates for the loss of policy flexibility.

Foreign Exchange Reserves

Foreign exchange reserves are assets held by a central bank in foreign currencies, used to back liabilities and influence monetary policy. These reserves include foreign currencies, gold, and International Monetary Fund (IMF) special drawing rights.

In a pegged exchange rate system, foreign exchange reserves are crucial because they are used to maintain the value of the pegged currency by buying or selling foreign exchange as needed. A country may use reserves to defend its currency against market pressures, ensuring that the exchange rate stays fixed.

• High reserves can boost investor confidence, as they signify a country’s ability to support its currency value.
• Adequate reserves are essential for managing external shocks and maintaining financial stability.
• Depleted reserves, however, can lead to devaluation pressures and a potential abandonment of the peg.

The challenge for countries is to maintain sufficient reserves, especially during economic downturns when the demand to buy foreign exchange often increases, leading to potential depletion and a forced currency revaluation.