Adjustable Peg (FOREX) - Explained
What is an Adjustable Peg?
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Table of ContentsWhat is an Adjustable Peg?How Does an Adjustable Peg Work?Example of a Currency PegAcademics Research on Adjustable Peg
What is an Adjustable Peg?
Adjustable peg is a foreign-exchange rate policy in which the domestic currency is measured in terms of standard currency such as U.S. dollar, but can be regulated as per the dynamic market scenario. Such flexible adjustments increase a company's potential in trade, especially in terms of export business.
How Does an Adjustable Peg Work?
Generally, an adjustable peg offers 2% flexibility as opposed to a given rate. In case, the exchange rate tends to go beyond 2%, the country's central bank comes into picture in order to keep the exchange rate fixed. The essence of adjustable peg system lies in the country's potential to re-evaluate its peg for getting a competitive edge. This term was devised during the United Nations Monetary and Financial Conference in 1944. As this conference took place in Bretton Woods, the agreement was named Bretton Woods Agreement in which different currencies were fixed in terms of gold price, and U.S. dollar was considered to be the reserve currency that was associated with the gold price. After this agreement, majority of the Western European countries resulted in pegging currencies to U.S. dollar. However, this agreement was dismissed between 1968 and 1973 when the U.S. dollar was valued beyond the set limits, thereby messing up with exchange rate and gold price levels. President Richard Nixon announced an interim dismissal of dollars convertibility policy. And, the nations could select exchange agreements based on their preference, excluding the gold price.
Example of a Currency Peg
If we had to take an example of a currency peg that mutually benefited both currencies, it would be that of Yuan (Chinas currency) and U.S. dollar. In December 2015, China disassociated with U.S. dollar, and in turn, switched to 13 different currencies. However, in January 2016, it sought a quick switch again. China, being an exporter, has an upper hand in foreign markets. Owing to its weak currency, its exports are cheaper as compared to those of competitors. Being the biggest exporter for U.S., China pegs its local currency (Yuan) to U.S. dollar. Also, several businesses in the U.S. get benefited from Chinas weak currency and consistent exchange rate. This consistency lets businesses develop long-run strategies knowing that currency fluctuations wont have any impact on the costs related to development and investment in imports. A drawback of a pegged currency can be the fact that it is maintained at an artificially lower rate, that suppresses competition in comparison to a floating exchange rate. Several local manufacturers in the United States believe that products that are priced lower, due to artificial exchange rate policy, drastically affect job opportunities in the U.S.
Academics Research on Adjustable Peg
- Demand for international reserves and exchange-rate intervention policy in an adjustable-peg economy, Levy, V. (1983). Demand for international reserves and exchange-rate intervention policy in an adjustable-peg economy. Journal of Monetary Economics, 11(1), 89-101. This paper develops and estimates a model of the joint determination of the official and black-market exchange rates, private and government demand for international reserves, and the rate of inflation under an adjustable-peg system. The framework presented combines and extends aspects of the monetary approach to the balance of payments and exchange-rate determination with the theory of the demand for international reserves. The role of expectations about devaluation is taken into account. The model is estimated by full-information maximum likelihood on the basis of quarterly data for Turkey.
- Adjustable pegs vs. single currencies: How valuable is the option to realign?, Gerlach, S. (1995). Adjustable pegs vs. single currencies: How valuable is the option to realign?. European Economic Review, 39(6), 1155-1170.One cost involved in going from an adjustable peg exchange rate regime to a system of irrevocably fixed exchange rates, by the introduction of a single currency, is that the participating members will forego the option to realign that is inherent in any adjustable peg system. This issue is of relevance in Europe, where the introduction of a European Monetary Union and a single currency is actively contemplated. This paper values the option to realign using recently developed methods of optimal regulation of Brownian motion, as exposited by Dixit (1991).
- Orderly exits from adjustable pegs and exchange rate bands, AGNOR*, P. R. (2004). Orderly exits from adjustable pegs and exchange rate bands. The Journal of Policy Reform, 7(2), 083-108. This paper examines the exit process from adjustable pegs and exchange rate bands, and the role of capital flows in these exits. It dwells on the experience of various countries, including Chile, Colombia, Egypt, Israel, India, Poland, and Yemen. It begins by identifying conditions under which exits are sought. Next, it discusses the prerequisites for a successful exit, factors affecting the pace of exit, and the nature of the postexit regime. It then examines the behavior of private capital flows, interest rates, and official reserves before and after three successful exits (Chile, India, and Poland), and draws broad policy lessons.
- Fiscal policies and the choice of exchange rate regime, Kock, G. D., & Grilli, V. (1993). Fiscal policies and the choice of exchange rate regime. The Economic Journal, 103(417), 347-358.
- Monetary control and the crawling peg, McKinnon, R. I. (1981). Monetary control and the crawling peg. In Exchange rate rules (pp. 38-54). Palgrave Macmillan, London. Why have several less developed countries, but no industrial economies, adopted a crawling peg? As Williamson notes (Chapter 1 above), academic discussion in the 1960s and 1970s was centred on applying the crawling peg to industrial economies as a modification of the dollar-based Bretton Woods method of setting official parities. Yet since 1973 many industrial economies have opted for floating, and none for crawling. Correspondingly, no less developed countries (LDCs), who typically limit the convertibility of their currencies, have opted for free floating; but since 1965 several have allowed their official parities to crawl smoothly downwards through time.