Currency peg

Key Takeaways

• A currency peg is established by a central bank or monetary authority to maintain stability in the exchange rate between the domestic currency and the reference currency.
• There are different types of currency pegs, including fixed pegs, crawling pegs, and basket pegs, each with varying degrees of flexibility.
• Currency pegs can provide stability in international trade and investment but may also require significant monetary policy intervention to maintain.

What is a Currency Peg?

Establishment

A currency peg is a mechanism used by central banks or monetary authorities to fix the exchange rate of their domestic currency to another currency or a basket of currencies. This fixed exchange rate system aims to provide stability in the value of the domestic currency relative to the reference currency or currencies.

Types of Pegs

• Fixed Peg: In a fixed peg system, the exchange rate is set at a specific rate and remains constant over time. The central bank intervenes in the foreign exchange market to maintain the fixed rate by buying or selling domestic and foreign currencies as needed.
• Crawling Peg: A crawling peg is a system where the exchange rate is adjusted periodically in small increments. This allows for some flexibility in the exchange rate to accommodate changes in economic conditions while still maintaining the pegged relationship.
• Basket Peg: Some countries peg their currency to a basket of currencies rather than a single currency. This basket may include currencies of major trading partners or currencies with significant importance in international finance.

Importance of Currency Pegs

Currency pegs serve several important purposes:

• Stability: By pegging their currency to a stable reference currency or basket of currencies, countries aim to reduce exchange rate volatility and promote stability in international trade and investment.
• Inflation Control: Currency pegs can help anchor inflation expectations and provide a framework for monetary policy by limiting the discretion of central banks to pursue independent monetary policies.

How Currency Pegs Work

A currency peg is maintained through central bank intervention in the foreign exchange market. If the domestic currency strengthens or weakens beyond the predetermined exchange rate, the central bank buys or sells foreign currency to maintain the pegged rate. This intervention requires the central bank to hold sufficient foreign exchange reserves to support the peg.

Real-World Application

• Hong Kong Dollar Peg: The Hong Kong dollar is pegged to the US dollar within a narrow trading band. This peg has provided stability to Hong Kong’s economy and facilitated its role as an international financial center.
• Saudi Riyal Peg: The Saudi riyal is pegged to the US dollar, ensuring stability in the exchange rate and providing certainty for businesses engaged in trade and investment with Saudi Arabia.

A currency peg is a fixed exchange rate system where the value of one currency is directly linked to another currency or a basket of currencies. Currency pegs can provide stability in international trade and investment but require active management by central banks to maintain. Understanding currency pegs is essential for assessing exchange rate risk and navigating the global economy.