Pegged Exchange Rates: The Pros and Cons (2024)

In June 2010, China's government decided to end a 23-month peg of its currency to the U.S. dollar. The announcement, which followed months of commentary and criticism from United States politicians, was lauded by global economic leaders.

China's economic boom over the last decade has reshaped its own country and the world. This pace of growth required a change in the monetary policy in order to handle certain aspects of the economy effectively—in particular, export trade and consumer price inflation. But none of the country'sgrowth rates could have been established without a fixed, or pegged, U.S. dollar exchange rate.

Chinese currency pegging is the most obvious recent example, but they are not the only one that has used this strategy. Economies big and small favor this type of exchange rate for several reasons, despite some potential drawbacks.

Pros of a Fixed/Pegged Rate

Countries prefer a fixed exchange rate regime for the purposes of export and trade. By controlling its domestic currency a country can—and will more often than not—keep its exchange rate low. This helps to support the competitiveness of its goods as they are sold abroad. For example, let's assume a euro (EUR)/Vietnamese dong (VND) exchange rate. Given that the euro is much stronger than the Vietnamese currency, a T-shirt can cost a company five times more to manufacture in a European Union country, compared to Vietnam.

But the real advantage is seen in trade relationships between countries with low costs of production (like Thailand and Vietnam) and economies with stronger comparative currencies (the United States and the European Union). When Chinese and Vietnamese manufacturers translate their earnings back to their respective countries, there is an even greater amount of profit that is made through the exchange rate. So, keeping the exchange rate low ensures a domestic product's competitiveness abroad and profitability at home.

Currency Protection

The fixed exchange rate dynamic not only adds to a company's earnings outlook, it also supports a rising standard of living and overall economic growth. But that's not all. Governments that have sided with the idea of a fixed, or pegged, exchange rate are looking to protect their domestic economies. Foreign exchange swings have been known to adversely affect an economy and its growth outlook. And, by shielding the domestic currency from volatile swings, governments can reduce the likelihood of a currency crisis.

After a short couple of years with a semi-floated currency, China decided during the global financial crisis of 2008 to revert back to a fixed exchange rate regime. The decision helped the Chinese economy to emerge two years later relatively unscathed. Meanwhile, other global industrialized economies that didn't have such a policy turned lower before rebounding.

Key Takeaways

  • By pegging its currency, a country can gain comparative trading advantages while protecting its own economic interests.
  • A pegged rate, or fixed exchange rate, can keep a country's exchange rate low, helping with exports.
  • Conversely, pegged rates can sometimes lead to higher long-term inflation.
  • Maintaining a pegged exchange rate usually requires a large amount of capital reserves.

Cons of a Fixed/Pegged Rate

There are downsides to fixed currencies, as there is a price that governments pay when implementing the pegged-currency policy in their countries. A common element with all fixed or pegged foreign exchange regimes is the need to maintain the fixed exchange rate. This requires large amounts of reserves, as the country's government or central bank is constantly buying or selling the domestic currency.

China is a perfect example. Before repealing the fixed-rate scheme in 2010, Chinese foreign exchange reserves grew significantly each year in order to maintain the U.S. dollar peg rate. The pace of growth in reserves was so rapid it took China only a couple of years to overshadow Japan's foreign exchange reserves. As of January 2011, it was announced that Beijing owned $2.8 trillion in reserves—more than double that of Japan at the time.

The problem with huge currency reserves is that the massive amount of funds or capital that is being created can create unwanted economic side effects—namely higher inflation. The more currency reserves there are, the bigger the monetary supply, which causes prices to rise. Rising prices can cause havoc for countries that are looking to keep things stable.

Example Concerning the Thai Baht

These types of economic elements have caused many fixed exchange rate regimes to fail. Although these economies are able to defend themselves against adverse global situations, they tend to be exposed domestically. Many times, indecision about adjusting the peg for an economy's currency can be coupled with the inability to defend the underlying fixed rate. The Thai baht was one such currency.

The baht was at one time pegged to the U.S. dollar. Once considered a prized currency investment, the Thai baht came under attack following adverse capital market events during 1996-1997. The currency depreciated and the baht plunged rapidly, because the government was unwilling and unable to defend the baht peg using limited reserves.

In August 1997, the Thai government was forced into floating the currency before accepting an International Monetary Fund bailout. Even so, between July 1997 and January 1998, the baht fell by as much as 56%.

Pegged Exchange Rates: The Pros and Cons (2024)

FAQs

What are the pros and cons of pegged exchange rates? ›

By pegging its currency, a country can gain comparative trading advantages while protecting its own economic interests. A pegged rate, or fixed exchange rate, can keep a country's exchange rate low, helping with exports. Conversely, pegged rates can sometimes lead to higher long-term inflation.

What are the advantages of pegged floating exchange rate? ›

Pegged regimes are associated with lower inflation, lower nominal and real exchange rate volatility, and greater trade openness—all of which are associated with faster growth.

What is a benefit of a peg policy? ›

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 currency peg can reduce uncertainty, promote trade, and boost economies.

What are 2 cons of a fixed exchange rate policy? ›

The disadvantages of a fixed exchange rate include:

Preventing adjustments for currencies that become under- or over-valued. Limiting the extent to which central banks can adjust interest rates for economic growth. Requiring a large pool of reserves to support the currency if it comes under pressure.

What are the cons of a fixed exchange rate policy? ›

Drawbacks of Fully Fixed Exchange Rates:

Countries cannot independently adjust their exchange rates to address changing economic conditions. Loss of Monetary Policy Autonomy: The country may be forced to adopt monetary policies that are not necessarily suited to its specific economic circ*mstances.

What are the disadvantages of pegged exchange rates? ›

Increased Foreign Influence: On the flipside, countries which adopt a currency peg face increased foreign influence in their domestic affairs. This is because their monetary policy is determined by another nation. A lot of times, this leads to a conflict situation.

What are the disadvantages of pegging currency? ›

Disadvantages of a Currency Peg
  • In the case of sizeable fluctuations in the reference currency or commodity, the domestic currency also experiences significant volatility.
  • If a currency is pegged at an overly low exchange rate, it deprives domestic customers the purchasing power of buying foreign goods.
Feb 1, 2024

What are the advantages and disadvantages of fixed exchange rates quizlet? ›

Fixed exchange rates reduce foreign exchange risk for companies with cross border trade. The major disadvantage of fixed exchange rate system is that it establishes a direct link between domestic and foreign inflation and employment.

What are the advantages and disadvantages of fixed and floating exchange rates? ›

Fixed exchange rates work well for growing economies that do not have a stable monetary policy. Fixed exchange rates help bring stability to a country's economy and attract foreign investment. Floating exchange rates work better for countries that already have a stable and effective monetary policy.

What is the purpose of a pegged exchange rate? ›

The purpose of a pegged exchange rate is to stabilise the value of the local currency, keeping it at a fixed rate in order to avoid exchange rate fluctuations.

What are two advantages of fixed exchange rate? ›

Advantages of Fixed Exchange Rate System

It ensures stability in foreign exchange that encourages foreign trade. There is a stability in the value of currency which protects it from market fluctuations. It promotes foreign investment for the country. It helps in maintaining stable inflation rates in an economy.

What is a benefit of a PEG policy quizlet? ›

what are the two benefits for a peg policy? First, a peg stabilizes the import and export prices for developing countries. Second, many countries with high inflation have pegged their currencies to the dollar in order to restrain domestic inflation.

What is an example of a pegged exchange rate? ›

For example, if a small nation that does a lot of trade with the USA decides to peg its currency to the US dollar, its currency will fluctuate in value in roughly the same manner as the USD. The practice eliminates high-magnitude fluctuations and makes the smaller economy's currency a safer investment.

What happens when a currency is pegged to the US dollar? ›

When a currency is pegged, or fixed, it is tied to another country's currency. Countries choose to peg their currency to safeguard the competitiveness of their exported goods and services. A weaker currency is good for exports and tourists, as everything becomes cheaper to purchase.

What are the disadvantages of pegging a country's currency to the U.S. dollar? ›

Disadvantages of Currency Pegs
  • Increased Foreign Influence: On the flipside, countries which adopt a currency peg face increased foreign influence in their domestic affairs. ...
  • Difficulty in Automatic Adjustment: A floating currency system leads to automatic adjustment of deficits.

What is the biggest disadvantage of a fixed exchange rate? ›

Disadvantages of a Fixed Exchange Rate

Lack of Monetary Policy Flexibility: Countries lose the ability to set their own interest rates and conduct independent monetary policy, as they must focus on maintaining the peg.

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