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A pegged exchange rate, also known as a fixed exchange rate, is where the currency of one country is tied to a usually stronger currency, such as the euro, US dollar or pound sterling. The purpose of this is to attempt to maintain the currency’s value, keeping it at a “fixed” rate and to avoid exchange rate fluctuations.
Advantages of a pegged exchange rate
There are a number of advantages of having a fixed exchange rate:
1. Creates stability for the value of the currency
The dangers of fluctuation are greatly minimised when a currency is pegged to another. For countries with weaker economies, such as some from African or Latin American countries, this is particularly important. A sudden exchange rate fluctuation could be potentially devastating for a fragile economy’s health. Pegging to a stronger currency protects it against such volatility.
2. Promotes foreign investment in the country
With greater currency stability in a country, in the knowledge that their investment’s value will not suddenly be wiped out due to exchange rate fluctuation, investors are more likely to invest than if the currency did not have a fixed exchange rate.
3. Assists a government in maintaining low inflation rates
A fixed exchange rate provides greater stability regarding import/export prices and provides protection against the possibility of currency devaluation. This stability helps a government to keep inflation rates low.
4. Promotes exports
Fixing an exchange rate assists a government in keeping their exchange rate low. A lower exchange rate promotes exports as the price of produce and services is more competitive.
Disadvantages of a fixed exchange rate
- Need to constantly maintain foreign currency reserves
In order to effectively control the currency’s exchange rate, the government must ensure there are sufficient foreign currency reserves through trading of the home currency. More foreign currency reserves can lead to higher inflation.
For emerging economies with a fixed exchange rate, rising inflation can be particularly disastrous, as prices rise, spending decreases as well as manufacturing output and foreign investment. They do not have the infrastructure and economic flexibility of a floated exchange rate that developed nations have to absorb shocks and recover from an economic slowdown.
Pegging a country’s exchange rate requires a stringent management structure.
- Limited flexibility to combat shocks
In the event of an economic shock, a government may be unable to respond effectively to arrest a decline in the value of their currency.
Should they have low foreign currency reserves, it can be practically impossible. Even if a government does use its limited currency reserves, it would then leave the home currency exposed to a host of potential issues including the potential creation of a lack of confidence in the home currency. This can be seen with the Venezuelan bolivar in recent years.
Though there are some risks associated with fixed exchange rates, there are many advantages. Pegged rates provide stability for countries that are particularly vulnerable to exchange rate volatility, and thus, a strong platform for a country to grow economically.