Question

Explain how exchange rates are determined under a pegged exchange rate system. Then thoroughly discuss the advantages and disadvantages of a pegged exchange rate system.

Answer 1

A fixed exchange rate, sometimes called a pegged exchange rate, is a type of exchange rate regime in which a currency's value is fixed or pegged by a monetary authority against the value of another currency, a basket of other currencies, or another measure of value, such as gold.

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The advantages of a fixed exchange rate include:

Providing greater certainty for importers and exporters, therefore encouraging more international trade and investment. Helping the government maintain low inflation, which can have positive long-term effects such as keeping down interest rate

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The disadvantages of a fixed exchange rate include:

Preventing adjustments for currencies that become under- or over-valued.

Limiting the extent to which central banks can adjust interest rates for economic growth.

Requiring a large pool of reserves to support the currency if it comes under pressure.