Understanding the concept of a currency peg

Table of contents

Table of contents

List of tables

List of abbreviations

1 Introduction

2 Fundamentals of a currency peg
2.1 Fundamentals and definitions of exchange rate systems
2.2 Types of fixed exchange rate systems
2.3 Current countries with a currency peg
2.4 History of fixed exchange rate systems – gold standard
2.5 Fixed exchange rate mechanism and development of crises

3 Advantages and disadvantages of a currency peg
3.1 Advantages of a currency peg
3.2 Disadvantages of a currency peg

4 Conclusion

References

List of tables

Table 1: Countries with a peg in 2018

List of abbreviations

IMF International Monetary Fund

1 Introduction

In the beginning of the year 2015 a change in exchange rate systems was observed as Switzerland decided to change its exchange rate system from pegging it to the Euro to a flexible one. A radical change in the value was noticed; it changed from the minimum rate of 1,20 Franken buying 1 Euro to just under 1 Franken, before on 31st May 2019 dropping back to around 1,12 Franken (vgl. Euro-Schweizer Franken-Kurs, 2019).

In this work an understanding for fixed exchange rates shall be developed, in order to be able to apply it in relation to flexible ones.

Currency policy is often viewed in connection with monetary policy (vgl. Genberg, 2008, p. 60), and is a complex topic with many different approaches to determine the exchange rate (vgl. Mooslecchner, 2008, p. 72); as it is a relative and not absolute price (vgl. Mooslechner, 2008, p. 65). In recent years exchange rates have played an increasing part in financial crises (vgl. Mooslechner, 2008, p. 66).

In 1923 a change in the dominant exchange system - the gold standard - occurred; from this time there were two exchange rate systems – fixed and flexible. Since then there has been an ongoing discussion as to whether fixed exchange rate systems are the better way of reaching countries’ economic goals. A crisis can be also a starting point to think about the pros and cons of the relevant exchange rate system and if it was a cause as well (vgl. Kaminsky, 2008, p. 50).

This work tries to find an answer to the fundamentals of currency peg from looking at the history to better predict the future, finding some ideas as to what should be considered in determining the exchange rate system.

The subject of this work is the fixed exchange rate system and will focus only on the technical aspect of the exchange rate and not the influences to which politicians are exposed (vgl. Frieden, 2015, p. 10).

The aim of this work is to obtain an overview regarding whether a currency peg is good or bad for a country, through taking a short look on the Mexican crises to find the main trend, namely if a fixed or flexible exchange rate is better.

For the literature research more recent literature is used for the latest state. The plethora of literature about currency systems and crises shows that it remains a current topic. Over the last century, different currency crises could be identified, with different reasoning behind each. Although the political system is not part of this question and won`t be considered separately, it nevertheless plays a role and thus cannot be ignored. Sources show that there are two main sides to the controversy – some authors preferring fixed exchange rate systems and the others preferring flexible exchange rate systems.

To answer the question, exchange rate systems will firstly be defined and the different types and countries using it will be described. Then the history, the gold standard, and the mechanism of fixed exchange rate systems and development of crises will be considered. Chapter three will look at the advantages and disadvantages of a currency peg including a brief examination on the Mexican crises as defined by the literature. In the final chapter a conclusion will be reached whether a currency peg is a favourable system.

2 Fundamentals of a currency peg

2.1 Fundamentals and definitions of exchange rate systems

Initially, there are different choices to be made regarding the exchange rate system (vgl. Frieden, 2015, p. 2–5) and a key point to acknowledge is the variety of exchange rate systems. It can be defined through the current global monetary situation like the gold standard or the European Monetary System in which the nation is in. However, it is also interpreted as the method of operating the exchange rate within the range of fixed and flexible exchange rates. Another is the price of the exchange rate. Monetary policies can influence through a range of mechanisms, i.e. changing the interest rate or taking action in the currency market, the value - appreciation or depreciation - of a currency against another currency (vgl. Frieden, 2015, p. 2–5).

The monetary base changes only when foreign exchange is bought or sold against domestic currency (vgl. Jarchow, 2002, p. 491). Inflows of foreign currency increase the money supply, and the development of the balance of payment determines the progress of the money supply, as with the gold standard. There is no sovereign money policy which increases authenticity (vgl. Jarchow, 2002, p. 491).

Governments have the choice of how to handle their currency (vgl. Frieden, 2015, p. 2–3), and there are different possibilities in which governments can establish an exchange rate in relation to other currencies. It can either be fixed to another currency or gold, and for this the value needs to be kept at a certain level in regards to another currency, or an alternative method is to utilise an adjustable peg. The government will maintain the exchange rate at a given point, but if it seems necessary it will adjust the given point. Ambiguity increases with this system as it is not possible to predict when the value will be altered. A further system is of course a flexible exchange rate. The value is generated on exchange markets; hence the governments will interfere in case the currency positively or negatively surpasses a certain point which is politically accepted, or if the currency requires stabilization. In general, the government doesn't keep to a specific value (vgl. Frieden, 2015, p. 2–3).

With a fixed exchange rate, the country has to comply with the monetary policy of the country from which it has chosen to detach its currency (vgl. Barnebeck Andersen, Thomas; Malchow-Moller, Nikolaj, 2014, p. 1).

For international competiveness and macroeconomic power the real exchange rate is important in measuring the value. The price in the domestic economy is not fully flexible, therefore the nominal exchange rate is fundamental to figure out the real exchange rate (vgl. Mooslechner, 2008, p. 65).

2.2 Types of fixed exchange rate systems

The IMF categorizes fixed exchange rate systems into two main types, which are known as hard pegs and soft pegs (vgl. International Monetary Fund, 2019, p. 44-45).

Hard pegs are arrangements with no autonomous currency or a board arrangement. The country adopts the currency of the anchor country, which is the used currency, named dollarization. For the board arrangement there is an obligation to change the currency at a fixed rate for a certain foreign anchor currency. This brings limitations such as no unrestricted monetary policy and no monetary control through the central bank for the country to realize their commitment.

Soft pegs include arrangements for stabilization, crawling pegs or pegs with bands. The currency is pegged to another currency or currency basket using (i.e. buying or selling) foreign currency or adjustments in the interest rate arrangements in relation to the exchange rate to preserve this fixed exchange rate. In comparison to hard pegs, it is not defined to absolutely maintain parity, instead keeping it between +/- 1% of a significant rate. A stabilization arrangement classifies that the exchange rate stays within a limit of 2% in relation to an analysed direction. If a fixed exchange rate is altered in narrow steps it is called a crawling peg (vgl. International Monetary Fund, 2019, p. 44-45). In the crawling peg system, the exchange alteration rate will be determined for a certain period and published, so the exchange rate stays predictable (vgl. Jarchow, 2002, p. 493). For a peg with a band where the exchange rate can fluctuate within boundaries are defined (vgl. International Monetary Fund, 2019, p. 44-45).

2.3 Current countries with a currency peg

According to the IMF there are currently 113 countries of a total of 189 countries which use soft or hard pegs. Table 1 show in parts countries which use a peg and to which the currency is pegged.

Abbildung in dieser Leseprobe nicht enthalten

Table 1: Countries with a peg in 2018

Source: Modelled after International Monetary Fund, 2019, p. 5-7

The majority of the countries using fixed exchange rate systems are developing countries.

2.4 History of fixed exchange rate systems – gold standard

Gold was the standard in the monetary system in the early 19th century (vgl. Muzhani, 2018, p. 21-22). As a commodity, it was used to specify the domestic currency with regard to the weight of gold. It was intended to have a huge amount of gold reserves, and replacements for gold occurred to only keep gold for conversion. Depending on the demand for money - gold or its replacement - the gold was allocated accordingly between the countries (vgl. Muzhani, 2018, p. 21-22).

The gold standard imitated the leading economies from the 1870s until 1914, and after World War I between the 1920s and 1930s (vgl. Frieden, 2015, p. 250–251). These nations regarded it as essential to retaining a holistic global economy; all nations would therefore comply with the worldwide standard economy. The gold standard was operated by these specifications and so each economy was expected to revert to harmonisation after a period of inequality. In some cases, this only could be managed with recession or deflation. Although this is a strict system and opposition did exist, their power to challenge this prevalent doctrine was low. This opposition comprised of farmers and other under-represented groups in the political system opposed to the dominance of the industrialized elite (vgl. Frieden, 2015, p. 250–251).

The exchange rate in this standard system was fixed for all members (vgl. Muzhani, 2018, p. 21, 23). The respective country authority bought or sold the gold theoretically at a wholly fixed rate, although in reality the rate changed within fixed boundaries (vgl. Muzhani, 2018, p. 21, 23).

The classic gold standard characterized a smooth balance of payment adjustment with no major financial crises, stable nominal exchange rates and long-term price stability (vgl. Jarchow, 2002, p. 482–484). Each nation specified a certain price in their currency for 1 kg of gold, and the gold parity was legally embedded. The fixed rate between nations accrued through division; only a small range for flexibility was available between gold import and gold export. Economies did not interfere with the adjustment process due to the in- and outflows of gold, and exchange equilibrium could therefore be reached. When gold outflows reversed - the exhaustion of the gold reserves was stopped - which was the very functioning of the mechanism. The exchange rate stability was seen credible as the gold parity was legally embedded and lasting with the anchoring of the balance of payment adjustment. With this trustworthiness and the small bandwidth, foreign exchange speculation had a stabilizing effect. Price stability was influenced by the production of gold; higher prices and hence higher cost led to a lower production of gold, and as a result the prices decreased (vgl. Jarchow, 2002, p. 482–484).

After World War I the gold standard was put back in place as the world currency system, but it soon proved difficult to maintain the stability of the system (vgl. Frieden, 2015, p. 251–252). In this time labour became strongly organized and further large corporations, both national and international operatives, began to exert greater influence on national economies. As a result, price and wage flexibility decreased, which made it harder for the regulation mechanism of the gold standard to continue functioning effectively. Concurrent with more influence the power of the opposition of the gold standard increased (vgl. Frieden, 2015, p. 251–252).

Price stability in the time of the gold standard had not only advantages but also disadvantages (vgl. Jarchow, 2002, p. 484–486). The wholesale prices were generally stable, but large fluctuations in real economic values like the real per capita income and employment occurred. In the nations with the gold standard, the prices and fluctuations had a homogeneous process - a similar economic situation. In conclusion, the countries did without monetary policy to stabilize economic activities. External goals were seen as more important than internal stability policy (vgl. Jarchow, 2002, p. 484–486).

A stronger focus to internal stability led also to the breakdown of the gold standard in 1931 after its reassertion in the 1920s (vgl. Jarchow, 2002, p. 486). With this internal focus, the expansion of money supply due to the inflow of foreign reserve assets was prevented by money policy actions. This was contrary to the rules of the gold standard in which the expansion and increasing of prices, although it reduced internal competitiveness, should be accepted to reset the balance of payments with reducing the excess of payments (vgl. Jarchow, 2002, p. 486).

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