May 20, 2022

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Advantages and disadvantages of Currency Pegs

What is Currency Peg? – Financial Gullak

Currency pegs are very popular in the post-Bretton woods currency world. Today, about a quarter of the world’s nation has its currency fixed in another major currency, the dollar or the Euro.

This strategy bankrupted certain countries such as Argentina and prospered others like China. Therefore, this strategy has certain advantages and disadvantages. This article lists both the advantages and disadvantages.

Advantages

Stable Basis for Planning: 

Currency pegs supply an extremely stable basis for financial planning to the authority. Governments have to buy basic commodities such as food and oil grains from the global market. Here, the authority has to pay its expenses in a foreign currency. Usually, this foreign currency is the United States dollar since it is the real-world’s reserve currency.

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However, other currencies like Euro are also accepted in the international market. However, the problem is the same whether you use dollars or Euros. The government needs to exchange its currency for another currency in the forex market.

Credible and disciplined monetary policy: 

Currency pegs are common in third-world countries. Impoverished countries in South America, Asia, and Africa employed currency pegs in the past. This is because these impoverished countries also serve as breeding grounds for corruption.

As a result, these countries do not have faith in their local leaders regarding monetary policy. There’s a good likelihood that the people who take control will end up producing hyperinflation.

Reduced volatility: 

Local companies, in addition to governments, benefit from currency pegs. Local businesses can forecast how much their items will cost worldwide. They can forecast the quantities demanded at the price once they know the specific pricing. However, they do not face any volatility and can protect themselves against foreign exchange losses.

Disadvantages

Foreign influence increased: 

On the other hand, countries that adopt currency peg suffer increased foreign influence in their domestic affairs. This is because another country establishes its monetary policy. This frequently results in a contentious situation. Consider the case of the pound sterling attack.

Difficulty in Automatic adjustment: 

A floating currency system automatically adjusts deficits. For example, if a country imports excessively, it will be forced to spend a large sum of money. This will result in a fall in their economy’s currency supply, resulting in deflation. Low prices result from deflation, and low prices make their exports competitive.

Speculative Attacks: 

Speculative attacks on a currency can occur only if it deviates significantly from its value. The value of freely floating currencies does not differ much from its inherent value. When there is a deviation, the market mechanism kicks in, and the correction occurs instantaneously. On the other hand, currency pegs might allow for a significant disparity between a currency’s inherent worth and its market value.

Conclusion

A pegged currency rate’s objective is to stabilize the value of the local currency by keeping it at a set rate to keep away from exchange rate swings.

To avoid an excess of under-or-over-valuation, a country may decide to stabilize its exchange rate through a fixed exchange rate.