The Downsides of Currency Pegs

Currency pegs have been used by many countries all over the world to benefit from the advantages that it brings their economy and currency. Indeed, it has brought order and better systems for the monetary policies of such countries that are using them. However, it is not fair to deny the fact that there are also some downsides to using currency pegs.

In this article, we will explore the various Forex Broker fsmsmart reviews disadvantages brought about by the usage of currency pegs in a country’s monetary policy. Read on to know more about currency pegs.

Higher Level of Foreign Influence

Countries that adopt a system of currency peg face a higher level of foreign influence in their domestic affairs. Simply put, their monetary policies are partly determined by another nation. In many cases, this results to a conflict.

For instance, Finance Brokerage Forex Brokers Reviews think about the attack on the British pound. During a time when the British government had pegged its currency to the German Deutschemark, the latter currency increased its interest rates because of domestic concerns over inflation.

The British wanted the interest rates to fall. However, there appeared no drop in rates. Because of that, the British pound took a heavy blow since the Bank of England was no longer in control of its affairs and the Bundesbank enjoyed an increased influence in Britain’s affairs.

Difficult in Automatic Adjustment

A floating currency system usually results to the automatic readjustment of deficits. For example, if a country imports too much, they will have to pay out a lot. This will result to a decrease in the currency supply in their economy and this in turn results to deflation, which means there will be low prices, making their exports competitive.

Therefore, increasing imports automatically results to a system of increasing exports. The free float system gravitates toward equilibrium. On the other hand, currency pegs usually exaggerates disequilibrium.

For instance, there is a massive trade and current account deficits between the United States and China. This vast difference is due to the peg between the dollar and the yuan. Therefore, currencies that have been pegged with each other are susceptible to disequilibrium.

This has already happened many times in the short economic history of free floating currencies and is expected to happen several more times in the future.

Speculative Attacks

Speculative attacks on a currency can only take place if its deviates too much from its value. Free floating currencies do not deviate too much from their value, however. The moment that deviation takes place, the market system sets in and correction occurs at the drop of the hat.

On the other hand, currency pegs can enable a huge difference between a currency’s market value and its fundamental value. This is due the fact that the central bank attempts to manipulate the value.

There are a number of financial funds and entities with enough resources to take on the central bank. When the currencies have gone well away from their fundamental value, the speculators manage to force devaluation.

In addition, there are times when the speculative attacks are so extreme that countries are forced to ditch the pegs and allow their currencies to be freely floating for a number of days.