A pegged exchange rate is the same thing as a fixed exchange rate. This type of exchange rate is when the government of one country fixes or pegs the value of its national currency to the value of a different country’s currency. When currencies are pegged, their values rise and fall in sync with one another.
Governments of countries with unstable economies often have unstable currency values, meaning the value of the national currency is susceptible to constant fluctuations. Constant changes in value mean constant changes in currency exchange rates, which deters trade and international investors due to currency exchange volatility. Countries may also peg their currency to the currency of their largest trading partner countries to simplify the trade process between the countries.
Developing nations or nations that have recently experienced a government regime change do not have a strong history of monetary and economic policy. As a result, these countries currencies tend to be weak in value, making economic growth and stability difficult. To help foster economic growth, increase trade, promote economic stability and attract foreign investors, it is not uncommon for these countries to peg their currency against a more economically stable nation’s currency.
Pegged currency values rise and fall together. For example, if Mexico pegs its peso against the U.S. dollar, as the dollar gains value or appreciates so, too, does the peso. The opposite is also true. By pegging its currency with to the dollar, Mexico’s monetary policy moves in conjunction with the monetary policy changes in the United States. For example, if the U.S. Federal Reserve Board decides to increase the Federal Funds Rate, it depreciates the value of the dollar due to higher interest rates. This monetary policy decision made by the U.S. Federal Reserve board has the same effect on the value of the peso, even though the Mexican government had no part in U. S. Federal Reserve Board’s monetary policy decision to raise the Federal Funds rate.
Maintaining Pegged Rates
To maintain pegged exchange rates, the central bank of the pegging country must hold large amounts of the currency to which it is pegged in a reserve account. For example, if Mexico pegs the peso against the U.S. dollar, it must hold large reserves of the U.S. dollar in its central bank. In this example, if the peso appreciates against the dollar, it can cause the currency exchange rate between Mexico and the U.S. to rise too far above the preferred exchange rate. Mexico’s central bank must purchase U.S. dollars in exchange for pesos. This increases the amount of pesos circulating in the Mexican economy, bringing the value of the peso back down and the currency exchange rate down to the preferred rate. If the peso depreciates, the central bank must purchase pesos in exchange for U.S. dollars to maintain the currency exchange rate. This decreases the amount of pesos circulating in the Mexican economy, increasing the value of the peso.