How Adjustable Peg works

An adjustable peg is where the central bank of a country maintains a currency's exchange rate by buying and selling foreign currencies for its own currency in the foreign exchange market. A peg is a type of exchange rate regime where a currency's value is fixed against either another national currency or a commodity, such as gold. The use of a fixed exchange rate encourages economic stability and the use of a currency by fixing a rate between that currency and another, usually stronger, currency. When a country has bilateral trade agreements that restrict its imports or exports or has other monetary restrictions, it may also have to use an adjustable peg.

An adjustable peg can be used on the market depending on market conditions, but it usually only has a two percent degree of flexibility against a fixed base level or peg. If the exchange rate deviates from the agreed-upon level, the central bank intervenes to maintain the peg to the target exchange rate. The peg itself can be re-evaluated and adjusted over time to reflect changing circumstances and trends. Each country's ability to revalue their peg in order to reestablish their competitiveness is central to the adjustable peg system.

Real World Example of Adjustable Peg

The Yuan (China's currency) and the US dollar are two examples of currency pegs that both benefitted from the adjustable peg system. China decoupled from the US dollar in December 2015 and, as a result, switched to 13 different currencies. However, in January 2016, it sought another quick switch. China, as an exporter, has an advantage in foreign markets, but because of its weak currency, its exports are less expensive than those of its competitors.

As the United States' largest exporter, China pegs its local currency (Yuan) to the US dollar. Furthermore, several businesses in the United States benefit from China's weak currency and stable exchange rate. Because of this consistency, businesses can develop long-term strategies knowing that currency fluctuations will have no effect on the costs of development and investment in imports. Several local producers in the United States believe that lower-priced products as a result of artificial exchange rate policy have a significant impact on job opportunities in the United States.

History of Adjustable Peg

The adjustable peg system arose from the 1944 United Nations Monetary and Financial Conference in Bretton Woods, New Hampshire. The Bretton Woods Agreement tied currencies to the price of gold, and the US dollar was viewed as a reserve currency tied to the price of gold. Most Western European countries pinned their currencies to the US dollar after Bretton Woods until 1971. Between 1968 to 1973, participating countries broke the agreement due to worries about the exchange rates and link to the price of gold.

An overvaluation of the US dollar caused the collapse. President Richard Nixon called for the temporary suspension of the convertibility of the dollar. Except for the price of gold, countries were then free to choose any exchange rate they wanted.