Unilaterally Pegged Exchange Rates - dummies

Unilaterally Pegged Exchange Rates

By Ayse Evrensel

Unilateral currency pegs appeared following the end of the Bretton Woods era. The difference between the pegged exchange rate regimes of pre- and post-1973 periods stems from the different types of money in these periods.

The Bretton Woods system implied a variation of the metallic standard called the reserve currency standard. While the dollar as the reserve currency was pegged to gold, other currencies were pegged to the dollar, which implies a fixed exchange rate system.

This kind of a system requires a multilateral agreement so that a country doesn’t change the exchange rate unilaterally. If it does, the international monetary system may be weaken or broken, which would necessitate redefining the pegs.

In the post Bretton Woods era, however, unilateral pegs started to appear. In this case, a country pegs the value of its currency to a foreign currency or a basket of foreign currencies.

In the early decades following the Bretton Woods era, especially developing countries were afraid of letting their currency float. Many were engaged in expansionary monetary policies that would have depreciated their currency at a faster rate if these currencies were floating. Therefore, many developing countries recognized that currency pegs can act as a nominal anchor and signal stability when economic and political stability is in short supply.

Additionally, they thought that a pegged exchange rate, pegged in a certain way, can serve these countries’ agenda regarding economic development.

There are different types of pegs among the unilateral currency pegs of the post Bretton Woods era. The most important difference between different types of pegs lies in their ability to restrict monetary policy in a country.

Pegs can be divided between hard and soft pegs. Pegs that make it almost impossible for a country to have an autonomous or independent monetary policy are called hard pegs. Soft pegs indicate that monetary policy actions are taken at times and the peg is adjusted from time to time. Soft pegs are also called crawling pegs.

The central bank guarantees convertibility of domestic currency into the foreign currency to which it is pegged. Therefore, keeping reserves of foreign currencies or international reserves, especially of the foreign currency to which the domestic currency is pegged, becomes important.