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Understanding Currency Pegs. Advantages of Pegged Exchange Rates. Disadvantages of Pegged Currencies. Example of a Currency Peg. Currency Peg FAQs. The Bottom Line.
Key Takeaways A currency peg is a policy in which a national government sets a specific fixed exchange rate for its currency with a foreign currency or basket of currencies. A realistic currency peg can reduce uncertainty, promote trade, and boost incomes. An overly low currency peg keeps domestic living standards low, hurts foreign businesses, and creates trade tensions with other countries.
An artificially high currency peg contributes to the overconsumption of imports, cannot be sustained in the long run, and often causes inflation when it collapses.
The United States has exchange rate arrangements with 38 countries, with 14 pegging their currencies to the USD. We also use third-party cookies that help us analyze and understand how you use this website.
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These cookies ensure basic functionalities and security features of the website, anonymously. The cookie is used to store the user consent for the cookies in the category "Analytics". Unlike the fixed rate, a floating exchange rate is determined by the private market through supply and demand.
A floating rate is often termed "self-correcting," as any differences in supply and demand will automatically be corrected in the market. Look at this simplified model: if demand for a currency is low, its value will decrease, thus making imported goods more expensive and stimulating demand for local goods and services. This, in turn, will generate more jobs, causing an auto-correction in the market.
A floating exchange rate is constantly changing. In reality, no currency is wholly fixed or floating. In a fixed regime, market pressures can also influence changes in the exchange rate. Sometimes, when a local currency reflects its true value against its pegged currency, an underground market which is more reflective of actual supply and demand may develop.
A central bank will often then be forced to revalue or devalue the official rate so that the rate is in line with the unofficial one, thereby halting the activity of the illegal market. In a floating regime, the central bank may also intervene when it is necessary to ensure stability and to avoid inflation. However, it is less often that the central bank of a floating regime will interfere.
Between and , there was a global fixed exchange rate. Currencies were linked to gold, meaning that the value of local currency was fixed at a set exchange rate to gold ounces.
This was known as the gold standard. This allowed for unrestricted capital mobility as well as global stability in currencies and trade. However, with the start of World War I, the gold standard was abandoned.
In , the "Bretton Woods Conference"—an effort to generate global economic stability and increase global trade—established the basic rules and regulations governing international exchange. As such, an international monetary system, embodied in the International Monetary Fund IMF , was established to promote foreign trade and to maintain the monetary stability of countries and, therefore, that of the global economy.
It was agreed that currencies would once again be fixed, or pegged, but this time to the U. This meant that the value of a currency was directly linked with the value of the U. So, if you needed to buy Japanese yen, the value of the yen would be expressed in U. If a country needed to readjust the value of its currency, it could approach the IMF to adjust the pegged value of its currency. The peg was maintained until when the U. From then on, major governments adopted a floating system, and all attempts to move back to a global peg were eventually abandoned in Since then, no major economies have gone back to a peg, and the use of gold as a peg has been completely abandoned.
The reasons to peg a currency are linked to stability. At least 66 countries either peg their currency to the dollar or use the dollar as their legal tender. The dollar is so popular because it's the world's reserve currency. World leaders gave it that status at the Bretton Woods Agreement. The runner-up is the euro. Twenty-five countries peg their currency to it. The 19 eurozone members use it as their currency. A dollar peg uses a fixed exchange rate.
A country's central bank promises to give you a fixed amount of its currency in return for a U. The country must have lots of dollars on hand to maintain this peg. As a result, most of the countries that use a U. Their companies receive lots of dollar payments.
They exchange the dollars for local currency to pay their workers and domestic suppliers. Central banks use the dollars to purchase U. They do this to receive interest on their dollar holdings.
If they need to raise cash to pay their companies, they may sell Treasurys on the secondary market. A country's central bank will monitor its currency exchange rate relative to the dollar's value. If the currency falls below the peg, it needs to raise its value and lower the dollar's value. It does this by selling Treasurys on the secondary market.
That gives the bank cash to purchase local currency. By adding to the supply of Treasurys for sale in the market, their value drops, along with the value of the dollar. This adjustment reduces the supply of local currency, raising its value, and the peg is restored.
Keeping the currencies equal is difficult since the dollar's value changes constantly. That's why some countries peg their currency's value to a dollar range instead of the exact number.
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