Chapter 14: Problem 5

Why do nations use a crawling peg exchange rate system?

Short Answer

Expert verified

Nations use a crawling peg exchange rate system because it provides a balance between flexibility and stability in the economy. It allows nations to respond to market changes, maintain economic stability by controlling inflation, and promote economic competitiveness.

Step by step solution

Understanding Crawling Peg System

A crawling peg system is a type of exchange rate regime that allows gradual depreciation or appreciation in an exchange rate. It is a hybrid of fixed and flexible exchange rate systems. A band of rates is predetermined within which the currency can fluctuate. The central bank modifies the fixed rate periodically based on certain indicators such as inflation.

Reason 1: Anticipate and Respond to Market Changes

Nations use a crawling peg system as it allows them to better anticipate and respond to market changes. By making moderate adjustments to the exchange rate periodically, the system provides some degree of flexibility. It enables a country to protect its economy from abrupt and potentially harmful currency shocks and to maintain economic stability.

Reason 2: Control Inflation Rate

A crawling peg system helps nations control inflation. The periodic adjustments to the exchange rate often reflect the inflation differential between the country and its trading partners. This means that if a country's inflation rate is higher than its counterparts, its currency would depreciate gradually over time, making its exports cheaper and imports more expensive, which in turn could help to contain inflation.

Reason 3: Promote Economic Competitiveness

The crawling peg system helps to promote economic competitiveness. Gradual adjustments in the exchange rate prevent dramatic changes that could negatively impact international trade. The adjustment takes into account various economic factors, and ensures that the currency's value remains relatively competitive without causing economic instability.

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