In today’s global economy, the value of a country’s currency is set by supply and demand on the FX market, a decentralized market where currencies from different countries are traded. The Bretton Woods system and other similarly fixed exchange rate regimes dominated the post-war decades of the twentieth century. Visit multibankfx.com
Since there is nothing backing fiat currencies save the government that issues them, some national central banks or monetary authorities seek a way to influence their currency’s value independent of market forces.
Keeping a currency pegged to another currency is one way for a government to influence the value of its currency on the forex market. As part of a currency peg, a country’s central bank will occasionally buy or sell its currency on the foreign exchange market.
What do you mean by currency peg?
A currency peg is a policy in which a country’s government sets a fixed exchange rate between its currency and a foreign currency or basket of currencies. A currency peg can make trade easier, reduce uncertainty, and help economies grow. A currency peg that is too low keeps living standards low, hurts foreign businesses, and makes trade between countries more difficult. A currency peg that is set too high causes people to buy too many imports and often causes inflation when it falls.
The value of one currency expressed in relation to that of another currency is referred to as the currency exchange rate. While the value of some currencies is allowed to vary based on supply and demand in the market, the value of other currencies is either fixed or linked to the value of another currency. Pegging ensures long-term predictability of forex trading rates, which is helpful for company planning and contributes to the maintenance of economic equilibrium.
ADVANTAGES OF CURRENCY PEGGING
About a quarter of the world’s countries today have fixed their currency’s value to that of another major currency.
Solid Foundation for Future Efforts
Governments may plan their budgets with great certainty when their currency is pegged to another. Oil and food grains are two examples of goods that governments must import from the international market. Here, the government must make its payments in a currency other than the one it uses. Since the US dollar is the world’s reserve currency, it is often exchanged for it. The Euro, however, is just one example of a non-U.S. currency that is widely accepted abroad.
The issue, however, is unaffected by whether the Euro or the Dollar is utilized. On the forex market, the government must trade its own currency for another. Constant fluctuations in exchange rates make it difficult for governments to plan for foreign currency purchases. Currency pegs, on the other hand, keep the exchange rate constant, giving governments a rock-solid foundation on which to base their budgets and spending plans in domestic currency without worrying about exchange rate fluctuations.
Effective and Reliable Monetary Policy
Many developing nations use currency pegs to stabilize their economies. Countries in South America, Asia, and Africa that are poor have historically employed currency pegs. This is since poor nations tend to be hubs of graft. Therefore, these nations do not have confidence in their government officials to handle monetary policy effectively. The new government has a significant likelihood of triggering hyperinflation.
Because of this, developing nations hope to outsource their monetary policy to a more advanced nation, in the hopes that its leaders will make better decisions. However, this does not eliminate the risk of sabotage by regional politicians. The reason for this is because governments may still generate inflation by ordering more currency to be printed. When a currency peg is in place, however, policymakers are unable to lower interest rates and fuel a boom in the forex tradingeconomy.
Modified Volatility
Currency pegs benefit not only governments but also local companies. Companies in the area can foresee the global selling prices for their products. When they know the exact price, they may estimate how much will be required. In this way, they are protected from any potential foreign exchange losses and are not subject to market fluctuations. In comparison to their rivals, who must absorb these costs and pass them on to customers through higher prices, this gives them a significant price advantage.
Why would a country choose to “peg” its currency?
One of the most prevalent motivations is to stabilize the economy, but others include decreasing the risks associated with growing into larger markets and boosting trade between countries.
DISADVANTAGES OF CURRENCY PEGS
Foreign influence increases
Countries that peg their currencies suffer increased foreign influence. Because another country sets its monetary policy. This usually causes strife. Consider the GBP attack. During that period, Britain tied its currency to the Deutschemark. The British pound suffered since the Bank of England was no longer in charge and the Bundesbank had more influence in Britain’s domestic affairs.
Auto-adjustment problems
Floating currencies repair shortfalls automatically. If a country imports too much, it must pay more. This reduces their currency supply, creating deflation. Deflation means low prices, which boosts exports.
Increasing imports inevitably boost exports. The free-floating system reaches equilibrium. Currency pegs exaggerate imbalance. Consider the large trade and current account deficits between the U.S. and China, which are produced by a dollar-yuan peg. Pegged currencies are disequilibrium prone. This has happened countless times in the short history of freely floating currencies and will happen again.
Attacks Speculative
Speculative attacks only occur when a currency deviates too much from its value. Freely floating currencies don’t fluctuate significantly. The market immediately corrects any deviation. Currency pegs can allow a large gap between a currency’s intrinsic and market value. The Central Bank manipulates the value.
Some financial funds can take on Central Banks, and it’s happened multiple times. Speculators devalue currencies that stray too far from their basic worth. Speculative attacks can be so severe that countries must abolish pegs and let their currencies float within days. When such an attack occurs, the average citizen faces significant losses due to overseas trade and investments. A freely floating currency is less vulnerable to attack. Currency pegs have this fundamental drawback. Know more https://multibankfx.com/platforms/mt4-platform
The Bottom Line
The policy of a nation’s government to maintain a constant exchange rate with another nation is referred to as “pegging” the currency. Most countries choose to peg their currencies to foster stability, trade, and investment from abroad.
