Adjustable Peg

Published Apr 5, 2024

Definition of Adjustable Peg

The adjustable peg is an exchange rate policy in which a country’s currency’s value is fixed relative to a major currency or basket of currencies but can be adjusted by the national monetary authorities in response to specific, predefined conditions. This system combines aspects of both fixed and floating exchange rate systems, aiming to provide stability in international transactions while allowing some flexibility in response to economic pressures.

Example

Consider a country that has pegged its currency, the X-Coin, to the US dollar at a rate of 1 X-Coin to $1. However, due to significant changes in trade balances or international investment flows, maintaining this fixed rate becomes economically unsustainable. The central bank of the country then decides to devalue the X-Coin to 1 X-Coin to $0.90. This adjustment is made to correct imbalances, improve the country’s export competitiveness, and address the economic pressures that have emerged.

Now, let’s imagine another scenario where the economy of the country experiences rapid growth, leading to inflationary pressures. In such a case, the monetary authorities might opt to revalue the X-Coin to 1 X-Coin to $1.10, making imports cheaper and helping to cool down the overheating economy.

Why Adjustable Peg Matters

The adjustable peg system offers a middle ground between the predictability of fixed exchange rates and the flexibility of floating rates. For businesses engaged in international trade, it provides a more stable environment than a purely floating system, reducing the risk associated with exchange rate fluctuations. For policymakers, it offers a tool to adjust the economy in the face of persistent external deficits or surpluses, inflation, or other macroeconomic imbalances.

Moreover, by retaining the ability to adjust the peg in response to economic indicators, countries can deter speculative attacks on their currency to some extent. Speculators might be less likely to bet against a currency if they know the government has both the policy flexibility and the willingness to adjust the peg in response to market pressures.

Frequently Asked Questions (FAQ)

How does the adjustable peg system differ from a purely fixed or floating exchange rate system?

The adjustable peg system sits somewhere between fixed and floating rate systems. Unlike a purely fixed rate, where the currency’s value is set against another currency or basket of currencies without change, the adjustable peg allows for periodic adjustments. This provides some flexibility to address macroeconomic imbalances. Unlike a floating rate system, where the currency’s value is determined entirely by market forces without governmental intervention, the adjustable peg involves deliberate adjustments by monetary authorities.

What are the conditions under which an adjustable peg might be adjusted?

Adjustments to an adjustable peg are typically made in response to significant economic imbalances. These could include persistent trade deficits or surpluses, inflation, changes in global economic conditions that affect the country’s economic performance, or speculative pressures on the currency. The specific conditions under which adjustments are made depend on the country’s economic policy goals and the challenges it faces.

What are the risks associated with an adjustable peg system?

While the adjustable peg offers a balance between stability and flexibility, it is not without risks. Frequent or poorly communicated adjustments can lead to uncertainty among investors and traders, potentially destabilizing capital flows. Moreover, if market participants believe an adjustment is imminent but delayed, it could invite speculative attacks, putting additional pressure on the economy. Additionally, maintaining an adjustable peg can be costly in terms of foreign exchange reserves and may limit a country’s ability to pursue independent monetary policy.