• Currency Pegging

    Foreign Exchange rate is the price/value of a foreign currency expressed in another base currency. Exchange rates may either be fixed or flexible depending on the strategy taken by the respective governments. An exchange rate is flexible or free to move when two countries agree to let the external and other market forces establish the rate through supply-demand of both the currencies. The rate fluctuates with the flow of country’s exports and imports, trade deficit, fund inflow and outflow and balance of payment.

    In a pegged exchange rate, the currency’s value is fixed by the respective government with respect to another currency, usually the US dollar which is the mostly used global currency.

    Countries having several important trading partners or the fears that a currency may be too volatile over an extended period of time, can chose to fix their currency to a single currency or a bucket of several other currencies. This leads to fixing to a weighted average of several currencies.

    How currency pegged rates are maintained

    A government has to work to maintain their pegged rate by maintaining large reserves of foreign currency so as to mitigate the changes in supply and demand. If a sudden rush of demand for a currency were to drive the exchange rate up, the national bank would have to work upon releasing enough of that currency through various channels into the market to meet the demand. They can also buyout the currency if the decrease in demand is lowering exchange rates.

    Advantages:

    One of the advantages of a fixed exchange rate regime is the check on rising inflation. Also, the fixed rate regimes are supposed to augment the economic growth by eliminating the exchange rate volatility. The central bank can magnetize international trade and provide the basis for faster growth.

    Disadvantages:

    The foremost disadvantage is the lack of policy autonomy retained under a fixed exchange rate. While the adoption of a strong anchor currency provides the credibility, stability, and predictability, the trade-off comes from import of the anchor currency’s monetary policies. As a result, the developing countries that fix their exchange rates lose control over the domestic money supply, as any increase in the domestic currency supply is offset by foreign exchange reserve losses. The fixed rate regimes can effectively absorb domestic monetary shocks, but not foreign monetary shocks.

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