Pegged currency

A fixed exchange rate, often called a pegged exchange rate, is a type of exchange rate regime in which a currency's value is fixed or pegged by a monetary authority against the value of another currency, a basket of other currencies, or another measure of value, such as gold.

There are benefits and risks to using a fixed exchange rate system. A fixed exchange rate is typically used to stabilize the exchange rate of a currency by directly fixing its value in a predetermined ratio to a different, more stable, or more internationally prevalent currency (or currencies) to which the currency is pegged. In doing so, the exchange rate between the currency and its peg does not change based on market conditions, unlike in a floating (flexible) exchange regime. This makes trade and investments between the two currency areas easier and more predictable and is especially useful for small economies that borrow primarily in foreign currency and in which external trade forms a large part of their GDP.

A fixed exchange rate system can also be used to control the behavior of a currency, such as by limiting rates of inflation. However, in doing so, the pegged currency is then controlled by its reference value. As such, when the reference value rises or falls, it then follows that the value(s) of any currencies pegged to it will also rise and fall in relation to other currencies and commodities with which the pegged currency can be traded. In other words, a pegged currency is dependent on its reference value to dictate how its current worth is defined at any given time. In addition, according to the Mundell–Fleming model, with perfect capital mobility, a fixed exchange rate prevents a government from using domestic monetary policy to achieve macroeconomic stability.

In a fixed exchange rate system, a country's central bank typically uses an open market mechanism and is committed at all times to buy and/or sell its currency at a fixed price in order to maintain its pegged ratio and, hence, the stable value of its currency in relation to the reference to which it is pegged. To maintain a desired exchange rate, the central bank during a time of private sector net demand for the foreign currency, sells foreign currency from its reserves and buys back the domestic money. This creates an artificial demand for the domestic money, which increases its exchange rate value. Conversely, in the case of an incipient appreciation of the domestic money, the central bank buys back the foreign money and thus adds domestic money into the market, thereby maintaining market equilibrium at the intended fixed value of the exchange rate.

In the 21st century, the currencies associated with large economies typically do not fix (peg) their exchange rates to other currencies. The last large economy to use a fixed exchange rate system was the People's Republic of China, which, in July 2005, adopted a slightly more flexible exchange rate system, called a managed exchange rate. The European Exchange Rate Mechanism is also used on a temporary basis to establish a final conversion rate against the euro from the local currencies of countries joining the Eurozone.

History

The gold standard or gold exchange standard of fixed exchange rates prevailed from about 1870 to 1914, before which many countries followed bimetallism. The period between the two world wars was transitory, with the Bretton Woods system emerging as the new fixed exchange rate regime in the aftermath of World War II. It was formed with an intent to rebuild war-ravaged nations after World War II through a series of currency stabilization programs and infrastructure loans. The early 1970s saw the breakdown of the system and its replacement by a mixture of fluctuating and fixed exchange rates.

Chronology

Timeline of the fixed exchange rate system:

Gold standard

The earliest establishment of a gold standard was in the United Kingdom in 1821 followed by Australia in 1852 and Canada in 1853. Under this system, the external value of all currencies was denominated in terms of gold with central banks ready to buy and sell unlimited quantities of gold at the fixed price. Each central bank maintained gold reserves as their official reserve asset. For example, during the "classical" gold standard period (1879–1914), the U.S. dollar was defined as 0.048 troy oz. of pure gold.

Bretton Woods system

Following the Second World War, the Bretton Woods system (1944–1973) replaced gold with the U.S. dollar as the official reserve asset. The regime intended to combine binding legal obligations with multilateral decision-making through the International Monetary Fund (IMF). The rules of this system were set forth in the articles of agreement of the IMF and the International Bank for Reconstruction and Development. The system was a monetary order intended to govern currency relations among sovereign states, with the 44 member countries required to establish a parity of their national currencies in terms of the U.S. dollar and to maintain exchange rates within 1% of parity (a "band") by intervening in their foreign exchange markets (that is, buying or selling foreign money). The U.S. dollar was the only currency strong enough to meet the rising demands for international currency transactions, and so the United States agreed both to link the dollar to gold at the rate of $35 per ounce of gold and to convert dollars into gold at that price.

Due to concerns about America's rapidly deteriorating payments situation and massive flight of liquid capital from the U.S., President Richard Nixon suspended the convertibility of the dollar into gold on 15 August 1971. In December 1971, the Smithsonian Agreement paved the way for the increase in the value of the dollar price of gold from US$35.50 to US$38 an ounce. Speculation against the dollar in March 1973 led to the birth of the independent float, thus effectively terminating the Bretton Woods system.

Current monetary regimes

Since March 1973, the floating exchange rate has been followed and formally recognized by the Jamaica accord of 1978. Countries use foreign exchange reserves to intervene in foreign exchange markets to balance short-run fluctuations in exchange rates. The prevailing exchange rate regime is often considered a revival of Bretton Woods policies, namely Bretton Woods II.

Mechanisms

Open market trading

Typically, a government wanting to maintain a fixed exchange rate does so by either buying or selling its own currency on the open market. This is one reason governments maintain reserves of foreign currencies.

If the exchange rate drifts too far above the fixed benchmark rate (it is stronger than required), the government sells its own currency (which increases supply) and buys foreign currency. This causes the price of the currency to decrease in value (Read: Classical Demand-Supply diagrams). Also, if they buy the currency it is pegged to, then the price of that currency will increase, causing the relative value of the currencies to approach what is intended.

If the exchange rate drifts too far below the desired rate, the government buys its own currency in the market by selling its reserves. This places greater demand on the market and causes the local currency to become stronger, hopefully back to its intended value. The reserves they sell may be the currency it is pegged to, in which case the value of that currency will fall.

Fiat

Another, less used means of maintaining a fixed exchange rate is by simply making it illegal to trade currency at any other rate. This is difficult to enforce and often leads to a black market in foreign currency. Nonetheless, some countries are highly successful at using this method due to government monopolies over all money conversion. This was the method employed by the Chinese government to maintain a currency peg or tightly banded float against the US dollar. China buys an average of one billion US dollars a day to maintain the currency peg. Throughout the 1990s, China was highly successful at maintaining a currency peg using a government monopoly over all currency conversion between the yuan and other currencies.

Open market mechanism example

Under this system, the central bank first announces a fixed exchange-rate for the currency and then agrees to buy and sell the domestic currency at this value. The market equilibrium