Covers exchange rate pegging.

1. Why might one country peg its
currency to that of another?

2. Where one currency’s value is tied to the
value of:
1) that of another currency
- e.g., USD/HKD = 7.7500
1) a basket of currencies to minimize
currency fluctuations
- e.g., SDR (composite currency)
1) some other measure of value (like gold)
What is a “pegged” exchange rate?

3. Some basic economic reasons
Exports and Trade
- Pegging holds attraction to economies seeking export-
driven growth
Ex. USD/LKR = 133

4. Helps limit inflation and other instabilities
- Moves in step with the reference currency/ies or
commodity/ies to which its pegged
- Nations with high inflation rates typically face high
deficits and loss of foreign currency reserves

5. Helps central banks acquire credibility
- patterns currency to that of a more
disciplined/developed nation
Reduces uncertainty -- i.e., “exchange rate risk”
Facilitate investment flows
Fixed/pegged exchange
rates diminish the degree
of volatility and variation in
relative prices

6. Provide money markets in a nation in which
these are illiquid, undeveloped, and otherwise unviable

7. Money market elaboration
1) Facilitates industry
- provides short-term loans
1) Helps trade w/ commercial finance available
2) Good for central banks
- money markets provide short-term interest rates
1) Self-sufficiency of commercial banks
- paucity of funds, can recall loans
1) Allows commercial banks to be financially successful
- excess bank reserves converted into bills of exchange

8. Economic Disadvantages
Enables trade deficits
- under a floating rate system this automatically balances
Economics of trade deficit rebalancing
- demand for foreign currency ↑
- price of foreign currency ↑
- in turn, foreign goods less appealing to domestic market
- trade deficit thereby diminishes

9. Disadvantages
Limits the ability to use monetary and fiscal policy at liberty
- stimulatory efforts typically decrease trade balances
To close a trade deficit, deflationary measures may be
utilized
- can lead to negative economic outcomes like
unemployment

10. Disadvantages
Floating exchange rates may help to determine CA
between nations
- has implications for efficient resource allocation
Broader array of sophisticated modern financial
instruments may render exchange rate pegging
unnecessary
Forex markets may not operate as efficiently as they would
otherwise due to government intervention efforts

11. Disadvantages
Desired exchange rate may not coincide with the
equilibrium exchange rate
- leads to excess supply or demand of a currency
In order to peg exchange rates, reserve currencies are
needed to absorb any excess supply or demand

12. How are exchanged rates fixed?
Open market trading
- Buying/selling its currency on the open market
- For a currency to appreciate, it will buy its own currency
using its foreign currency reserves (increase demand)
- For a currency to depreciate, it will sell its own currency
and buy foreign currency (decrease demand)
- To avoid inflation/deflation as a result of money supply
fluctuation, gov’t bonds may be sold/purchased

13. How are exchanged rates fixed?
Through fiat (legal decree)
- unpopular due to the threat of black market activity
- can be used effectively with government monopolies
designed to govern currency conversion

14. Notable Int’l Examples of Pegging
- European Union (EU)
- Denmark (through ERM II), Bosnia and Herzegovina
(Deutschmark), Bulgaria (Deutschmark)
- Switzerland (tied to Euro until January 2015)
- China yuan to USD
- Ecuador, El Salvador, Panama (dollarization)

15. References
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____Research, 2000.
Calvo, Guillermo, and Frederic S. Mishkin. The mirage of exchange rate regimes for emerging market
countries. ____No. w9808. National Bureau of Economic Research, 2003.
Caramazza, Francesco, and Jahangir Aziz. "Economic Issues No. 13 -- Fixed or Flexible?--Getting the
____Exchange Rate Right in the 1990s." IMF -- International Monetary Fund Home Page. Last modified 1998.
____http://www.imf.org/external/pubs/ft/issues13/index.htm.
Dooley, Michael. International financial stability: Asia, interest rates, and the dollar. Deutsche Bank AG, 2005.
Garber, Peter M., and Lars EO Svensson. The operation and collapse of fixed exchange rate regimes. No.
____w4971. National Bureau of Economic Research, 1994.
Obstfeld, Maurice, and Kenneth Rogoff. The mirage of fixed exchange rates. No. w5191. National bureau of
____economic research, 1995.
Poirson, Helene. "How do countries choose their exchange rate regime?." (2001): 1-34.
Reinhart, Carmen M. "The mirage of floating exchange rates." American Economic Review (2000): 65-70.
Tatom, John A. "The US-China currency dispute: Is a rise in the yuan necessary, inevitable or desirable?."
____Global Economy Journal 7, no. 3 (2007).