Currency Pegging

Posted in Finance, Accounting and Economics Terms, Total Reads: 786
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Definition: Currency Pegging

Currency pegging, which leads to “pegged exchange rate” or “fixed exchange rate”, is the process of keeping the exchange rate of a country fixed against the value of a group of other currencies or a single other currency or to other measures like gold. Exchange rate is the rate by which Central bank of a country exchanges its currency with any other foreign country.

A pegged exchange rate leads to a stabilized value of home currency. This in turn makes trading and investing activities between two countries simpler and more predictable. It allows traders to know the exact exchange rate that they can expect for their transactions, which leads to curbing of inflation and tempering of interest rates. Hence this type of exchange rate system is especially useful for small economies where external trade forms a major chunk of their GDP. Nowadays no major country follows this pegged rate system.

Since the exchange rate is pegged to a reference value, any fluctuations in reference value leads to changes in pegged currency as well. This prevents a government from using monetary policy to achieve economic stability. This fixed exchange rate has to be artificially maintained by the government. It does so by either selling or buying its own currency in the open market. If the exchange rate falls down, the government buys backs its currency using its reserves. This increases the demand of its currency, thus pushing the prices up. The government sells its currency in the opposite case.

This constant requirement of intervention of government to keep the rate from fluctuating and the inability of automatic rebalancing of trade deficit has led to the criticism of this exchange rate system.


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