Pegged Exchange Rate Regime

A pegged exchange rate regime is also called a Fixed Exchange Rate, which means the currency’s value is being matched to another single currency’s value or it could be matched to a basked of several currencies or to some type of measure of value to include gold.  While a pegged exchange rate regime is used for a variety of reasons, it is most commonly associated with stabilizing currency value to the other currency pegged to which makes investments and trades between the two countries more predictable.

Now, the pegged exchange rate regime is also used in some cases to help control the problem of inflation.  In this case, as the referenced value begins to rise and fall, the currency it is pegged to also fluctuates.  Then, when looking at the theory known as the Mundell Fleming Model, if there is perfect capital mobility in place, the pegged exchange rate regime would stop a country’s government from using its own domestic monetary policy as a means reaching macroeconomic stability.

The bottom line is that the pegged exchange rate regime is one whereby the value of one currency would be fixed in terms of a second currency.  Of all the primary economic players in the world, the People’s Republic of China is the only one with a fixed exchange rate.  Other countries now use what is known as a floating exchange rate, which operates differently.

In most cases, when a country’s government wants to maintain a fixed exchange rate for its currency, this would be accomplished by buying or selling the country’s own currency on the open market, which is why so many countries keep foreign currencies in reserves.  Additionally, some countries will maintain a pegged exchange rate regime by making trade currency at any other rate an illegal act.  The problem is that this setup would be extremely hard to enforce and it creates risk of a black market specific to foreign currencies.

While some countries believe the pegged exchange rate regime has benefits, others feel is that the rates being flexible mean an adjustment of balance of trade automatically.  In this case, if there were a trade deficit, the demand for foreign currency over domestic currency would increase.  When this happens, the price of the foreign currency would increase, which then makes foreign goods lose appeal to the domestic market while also causing the trade deficit to drop.

Overall, financial experts believe that the pegged exchange rate regime will help bring stability to a country and while this is true to some degree, there are some risks as well.  For example, making speculations are notorious for targeting currencies that have a pegged exchange rate regime.  In fact, capital control maintains the economic system that provides stability.  Therefore, the best way to perceive a pegged exchange rate regime is it being a capital control tool.  While there are positive and negative aspects for this regime, it has been beneficial for many countries when it comes to currency exchange rates.