When we talk about a currency peg, it typically means that a country has enacted a currency policy. Here, it fixes its currency’s value against another currency. In most cases, countries have a dollar peg. This is because USD is one of the most stable and reliable currencies in the world.
So what does a currency pegged to USD entail for a country? Furthermore, how does in the long run a USD peg help them economically? Let’s find out.
Dollar Peg – The Summary
- A dollar peg is a form of currency policy where a country chooses single or multiple currencies. It then fixes its exchange rate against it.
- This policy helps the economy of the country to become stable and grow by promoting trade. This improvement, in turn, helps in minimizing uncertainty a lot.
- If you keep this currency peg, such as the dollar peg, relatively low, it will have a detrimental effect on your economy and businesses. This peg will inadvertently cause difficulties in trading with other countries.
- In the case of your currency peg being relatively high, your nation will import tons more goods than needed, which will cause massive inflation.
What is Currency Peg in General Terms?
Think of it as a fixed exchange rate. Your currency increases or decreases in value if the currency is pegged to another currency or valuable commodity. Most of the time, a currency pegged to USD or gold as both have become valuable and stable in their value.
Most countries will assign a standard value to their currency that is attached to how valuable it is when compared to the USD peg. The prime reason behind it is the foreign policies of the US and the easy availability of the dollar in most countries and markets.
How Does Dollar Peg Work?
You must have heard of gold reserves in the central bank and how secure a currency becomes because of that. The reason behind this is that it allows the country to maintain the supply of gold in the market. The higher the gold reserves, the more valuable their currency and their play in the market become.
A similar is the case when it comes to the dollar peg. The central bank of any country buys the US Treasury because first, they can get interest on that. Secondly, they can sell the US Treasury to the market to gain commodities and dollars.
This method allows the country to maintain its fixed exchange rate because it can quickly sell the treasury and increase its currency value by having more of it in reserve. The more they have, the lesser the dollar value becomes.
Now, with the selling of treasury, the bank can buy more local currency, reducing its flow in the market. Plus, now there is more treasury available in the market, hence reducing the value of the dollar. Because of both these effects, the country or central bank can quickly increase its dollar peg value.
Advantages and Disadvantages of a Currency Peg
Most commonly, the dollar peg isn’t the only policy countries employ, as the Euro and gold do have a comparable standing. This allows for diversity and makes it easier for countries to go into trade deals.
Let's start with the advantages of a Currency Peg.
Advantages
- You can easily trade with countries that have the same currency peg as yours and boost your economy through income.
- It helps to keep the currency fluctuation at minimal volatilization.
- With minimal rate changes, companies and businesses can benefit from better exchange rates, improved tariffs, and better exchange from specialized trading.
- Allows for long-term investment in infrastructure projects, especially in developing countries.
Disadvantages
- You need to diligently monitor the exchange rates and maintain proper cash flow to make sure that the spikes aren’t too difficult to manage.
- The central bank must have enough reserves to stop any manipulation of the market by local businesses and other countries to cause destabilization.
- If the currency peg has caused it to be set at a deficient value, individuals and businesses lose the buying power to buy and trade in foreign goods.
- The higher the exchange rate of the currency peg is, the more imports gain more profit from individuals. This reaction causes a reduction in local industry.
Important Questions Regarding Dollar Peg
What is the Significance of A Country Pegging Their Currency?
It allows for the country to trade with countries that also have the same currency peg. This causes stability in trade, makes it easier to fulfill transactions, and helps broaden their market and reach.
Is There Any Long-Term Effect of Currency Peg Break?
If your Central Bank has realistically set the exchange rate for a currency peg, it isn’t that easy for other factors to manipulate the exchange rate. Individuals and institutions, like currency traders, markets, etc., can easily buy the currency and threaten to destabilize the market. This manipulation causes a currency peg break, which destabilizes the value of the currency. If the destabilization continues longer, the local economy will have difficulty maintaining inflation, and they can no longer defend their peg.
What is a Soft Currency Peg?
In this policy, a country or central bank allows the market dynamics to maintain the currency exchange rate for the currency. This helps to enhance forex trading and builds up reserve. But this can easily be manipulated by floating too much currency, in which case the central bank has to jump in and stop this manufacturing of artificial hikes.
Final Words
Currencies allow countries and their individuals to trade in the international market, creating a balance and homogeny in the market. It can be further enhanced if a country pegs a common currency, making it easier to trade resources against money.
Therefore, it is necessary to understand how currency peg works if you want to deal in the international market.
