Definition
A pegged currency, also known as a fixed exchange rate currency, is a currency that maintains a stable exchange rate with another currency, typically a stronger or more stable one. This fixed rate is achieved through government or central bank intervention in the foreign exchange market.
Detailed Explanation
Pegged currencies are designed to provide greater stability in foreign exchange markets by reducing uncertainty in international trade and investment. The central bank commits to buying and selling its currency at a fixed rate to another currency. This practice helps manage inflation and create a predictable economic environment.
Mathematically, the fixed exchange rate can be denoted as:
Where:
- \( E_{fixed} \) is the fixed exchange rate.
- \( C_{home} \) is the value of the home currency.
- \( C_{foreign} \) is the value of the foreign currency.
Historical Context
Origin and Development
The concept of pegged currencies became prominent in the mid-20th century, particularly with the establishment of the Bretton Woods system post-World War II. Under this system, currencies were pegged to the US dollar, which was convertible to gold. However, the Bretton Woods system collapsed in the early 1970s, leading to the adoption of various exchange rate regimes by different countries.
Types of Pegged Currencies
Hard Peg
A hard peg implies a very strong commitment to maintaining the fixed exchange rate, often seen in currency boards or dollarization practices. For example, Hong Kong maintains a currency board that pegs the Hong Kong Dollar to the US Dollar.
Soft Peg
A soft peg allows some flexibility in the exchange rate but keeps it within a narrow band around a fixed value. Countries like China have historically used a managed float system, where the Yuan’s value is pegged to a basket of currencies but allows for minor fluctuations.
Advantages and Disadvantages
Advantages
- Stability in Trade: Pegged currencies provide stable exchange rates, encouraging international trade and investment by reducing currency risk.
- Inflation Control: Helps in controlling inflation rates, as the pegged currency must adjust to the inflation rate of the currency it is pegged to.
- Predictability: Creates a predictable economic environment, fostering business confidence and economic planning.
Disadvantages
- Loss of Monetary Policy Control: Limits a country’s ability to adjust its monetary policy independently in response to domestic economic conditions.
- Vulnerability to Speculative Attacks: Fixed rates can attract speculative attacks if traders believe the peg is unsustainable.
- Balance of Payments Issues: Persistent fixed exchange rates can lead to imbalances in the balance of payments, requiring significant reserves to maintain the peg.
Examples
Successful Pegs
- Hong Kong Dollar (HKD): Pegged to the US Dollar at approximately 7.8 HKD/USD.
- Danish Krone (DKK): Pegged to the Euro within a narrow band.
Unsuccessful Pegs
- Argentinian Peso (1991-2002): Pegged one-to-one with the US Dollar, leading to severe economic crisis when the peg could not be maintained.
- Thai Baht (Pre-1997): Pegged to the US Dollar until a speculative attack during the Asian Financial Crisis led to a floating exchange rate.
FAQs
What is the difference between a pegged and a floating currency?
Why do countries peg their currency?
How do central banks maintain a pegged currency?
Can a pegged currency system fail?
Summary
Pegged currencies play a critical role in the global financial system by providing stability and predictability in international trade and investment. However, maintaining a fixed exchange rate requires significant reserves and can limit a country’s ability to respond to economic fluctuations independently. The success of a pegged system depends on the economic conditions and the central bank’s ability to manage the peg sustainably.
References
- “Exchange Rate Regimes: Fix or Float?” by Michael W. Klein and Jay C. Shambaugh, Finance & Development, December 2010.
- “The Economics of Pegged Exchange Rates” by Robert P. Flood and Peter M. Garber, MIT Press, 1994.
- IMF Exchange Rate Arrangements and Exchange Restrictions Annual Report, International Monetary Fund, 2020.
