Question

What are the advantages and disadvantages of pegging the currency of a developing country to a major currency such as the U.S. dollar? List the specific conditions that are incompatible with pegging

Answer 1

ANSWER:

A dollar peg is when a country maintains its currency's value at a fixed exchange rate to the U.S. dollar. The country's central bank controls the value of its currency so that it rises and falls along with the dollar. The dollar's value fluctuates because it’s on a floating exchange rate.

• Advantage: Currency pegging provides stability to a currency. This provides predictability in terms of the amount of payment in international trade. A stable currency reduces the risk of currency volatility faced by the traders.
• Currency pegs have become extremely popular in the post Bretton Woods monetary world. About one fourth of all countries in the world today have pegged their currencies to some other major currency like the dollar.
• Disadvantage: Currency pegs often become unsustainable and the peg breaks. In order to keep a currency pegged against precious metal such as gold or silver, the central bank of the country needs to get actively involved in open market operations to buy or sell these metals and have a reserve of these metals. In the case of wide fluctuations in the price of these commodities, the peg may be unsustainable as maintaining the peg becomes too costly.

Britain had been forced to abandon its currency peg with Germany, in 1992, because it was in recession even as Germany enjoyed a boom. In the present day, China faces a related conundrum. It would like to open itself fully to capital flows in order to create a modern financial system, in which market forces play a bigger role. But doing so at a time of sluggish economic growth raised fears that the yuan would dive. As markets panicked, China’s capital controls were swiftly tightened.

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