Question

Explain why the degree of capital mobility might affect the sustainability of ‘soft’ currency pegs and ‘hard’ currency pegs.

Answer 1

A soft peg requires stable value of domestic currency w.r.t. other currency or basket of currency. If there is a higher degree of capital mobility, then movement of capital in and out of the country will be fast. It will put more pressure upon the exchange rate, causing the central bank to act swiftly to either buy or sell the currency to create artificial demand or supply as & when required to bring stability to the exchange rate of currency and subsequent maintenance of soft peg. Hence, higher degree of capital mobility affect high pressure upon the soft peg. In comparison to it, hard currency peg involves fixed exchange rate and higher degree of capital mobility creates relatively bigger pressure upon the fixed exchange rate as it has a higher tendency to change. It will put the central bank into the frequent action to act in the forex market so that fixed exchange rate is achieved. Such intervention will be less when there is less when there is a lower level of capital mobility. Hence, there is an inverse relationship between the degree of capital mobility and the sustainability of soft and hard currency peg.