The Pros and Cons of a Pegged Exchange Rate
A pegged exchange rate happens when a government attempts to maintain the value of its currency by measuring it against another country’s currency. A good example of this system was the European Exchange Rate Mechanism ERM even though it was semi-fixed way of checking the stability of member states’ currency. Under this regime, the government does not allow its currency to float depending on prevailing economic conditions but a limit at which the rates must stay. To achieve this, it must put in place measures, which ensures that the currency does not fluctuate regardless of the market changes. While this is the case, the system does not guarantee a smooth sailing; it has its difficulties. This piece discusses the pros and cons of a pegged exchange rate, which a government to consider before making a final decision on which system to adopt.
A summary of the pros and cons of a pegged exchange rate
The first advantage of a pegged exchange rate is that it helps to prevent currency fluctuation. While currency fluctuations are common in any economic system, they may affect trade when they become significant. This creates the need to have a cap that regulates the oscillations. For example, if a European country were exporting its products to the United States when the sterling is appreciating rapidly, the exports would be uncompetitive. This creates the risk of the company crumbling and exiting the market.
Secondly, a pegged exchange rate means economic stability, which encourages investment. Currency stability is a pull factor for investors. With high levels of uncertainties of the exchange rate, firms may have limited capacity to invest in exports. It is on this account that economists see UK’s reluctance to join the Euro and have a stable currency as the reason making her less attractive to potential investors. Investors all over the world focus on the economic predictability of the exchange rate system before advancing their business ventures. Thus, the pros and cons of a pegged exchange rate largely determine future of a country in terms of creating an acceptable or hostile business environment.
Other benefits of pegged exchange rate
An important advantage of a pegged exchange rate is its ability to tame inflation. Many countries overcome abnormal rates of inflation by setting the value of its currency using an economically stable country. By allowing the devaluation of the exchange rate, this may result into inflationary pressure stemming from high prices, which limit company’s incentives to reduce costs. Furthermore, when a country joins a pegged exchange rate system, the risk of inflation goes down. This gives hope to the investors and allows business to thrive, whether large scale or small scale.
Demerits: The pros and cons of a pegged exchange rate
The pros and cons of a pegged exchange rate make some people consider a floating exchange rate as a better option. Despite the fact that a pegged exchange rate offers a wide of advantages, it also presents numerous demerits, which monetary policy makers must have in mind choosing it as a preferred system. Firstly, this system is an avenue of conflicts with several objectives. In order for a country to implement a fixed exchange rate policy effectively, it may result into conflicts with existing macroeconomic objectives. In the event a currency falls below its limit, the government may choose to intervene by buying the sterling. However, this might not offer a long-term solution to the problem.
While a pegged exchange rate if capable of taming inflation, its undoing is its rigidity. Once a government adopts this system, it becomes hard to respond effectively economic shocks in the market. This creates unfavorable conditions for investors, especially when facing a balance of payments deficit with no chance of devaluation. Another demerit is the likelihood of joining the system at a wrong rate limit. In case the rate is too high, this will make a country’s exports less competitive and kick out some players from the market.
On the other hand, very low rates lead to inflation. From the pros and cons of a pegged exchange rate we have discussed, it is clear that a country ought to make an informed decision when adopting it as its preferred system.
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References:
http://2012books.lardbucket.org/books/policy-and-theory-of-international-finance/s16-05-which-is-better-fixed-or-float.html
http://www.dartmouth.edu/~jshambau/Papers/fixedEandMpolicy2003qjeforthcoming.pdf
http://www.grips.ac.jp/teacher/oono/hp/lecture_F/lec09.htm
http://www.investopedia.com/articles/forex/08/pegged-vs-floating-currencies.asp
http://www.streetdirectory.com/travel_guide/162674/banking/fixed_versus_floating_exchange_rate.html