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Chapter 30: Problem 4

What does it mean when one currency is "pegged" against another currency? Why do countries peg their currencies? What problems can result from pegging?

Short Answer

Expert verified
Currency pegging is essentially fixing an exchange rate to another country's currency or the price of gold, with the aim of stabilizing the exchange rate. Countries peg their currencies primarily for economic stability and to facilitate trade and investment. But crucial problems can arise, such as loss of monetary policy independence and the potential for overvaluation or undervaluation of the pegged currency, leading to potential account imbalances and social unrest.

Step by step solution

01

Understanding Currency Pegging

Currency pegging refers to a country's practice of fixing its exchange rate to another country's currency or the price of gold. The purpose of this scheme is to stabilize the exchange rate. In a pegged regime, the country's central bank uses its foreign exchange reserves to buy or sell foreign currency in the market to balance supply and demand, thereby maintaining a fixed exchange rate.
02

Reasons for Currency Pegging

Countries peg their currencies for several reasons. One of the main motives is to stabilize the exchange rate, reducing the risk of exchange rate fluctuations, and therefore facilitating trade and investment. It can also be done to stabilize a country’s economy, especially for those with weak or under-developed financial systems, or to prevent inflation, as it forces the country to follow the fiscal and monetary policies of the country to whose currency it is pegged.
03

Problems from Pegging Currencies

Despite the aforementioned benefits, currency pegging can bring about problems. Currency pegging can reduce a country's monetary policy independence, as it must follow the fiscal and monetary policies of the country to which it’s pegged. If the pegged currency becomes overvalued, this can lead to a balance of payments deficit. On the other hand, if it becomes undervalued, it may lead to inflation and social unrest. Currency pegging can be hard to maintain, especially in a downturn, leading to depletion of the country's foreign exchange reserves.

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Most popular questions from this chapter

On page 1074 , the text states that "the globalization of financial markets has helped increase growth and efficiency in the world economy." Briefly explain which aspects of globalization help to increase growth in the world economy.

An article in the Atlantic referred to a poll of economists that found no support for the United States to readopt the gold standard: It prevents the central bank from fighting recessions by outsourcing monetary policy decisions to how much gold we have -which, in turn, depends on our trade balance and on how much of the shiny rock we can dig up. When we peg the dollar to gold we have to raise interest rates when gold is scarce, regardless of the state of the economy. Why does the writer state that a gold standard would prevent "the central bank from fighting recessions"?

Briefly describe the four determinants of exchange rates in the long run.

According to the theory of purchasing power parity, if the inflation rate in Australia is higher than the inflation rate in New Zealand, what should happen to the exchange rate between the Australian dollar and the New Zealand dollar? Briefly explain.

An article in the Wall Street journal stated, "The years long battle that smaller European central banks (such as the central bank of Switzerland) have waged against their own strong currencies may have turned a corner, thanks to the strengthening euro." The article further noted that the "Swiss National Bank's foreign-exchange reserves accumulated on a massive scale since 2012 - dipped slightly last month." a. Why would the Swiss National Bank (the central bank of Switzerland) wage a battle against its own strong currency? b. Is there a connection between the Swiss National Bank waging a battle against its strong currency and the Swiss National Bank accumulating massive amounts of foreign exchange reserves? Briefly explain.
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