Fixed exchange rate system
In other words, a pegged currency is dependent on its reference value to dictate how its current worth is defined at any given time.
In addition, according to the Mundell–Fleming model, with perfect capital mobility, a fixed exchange rate prevents a government from using domestic monetary policy to achieve macroeconomic stability.
In a fixed exchange rate system, a country's central bank typically uses an open market mechanism and is committed at all times to buy and sell its currency at a fixed price in order to maintain its pegged ratio and, hence, the stable value of its currency in relation to the reference to which it is pegged.
Typically, a government wanting to maintain a fixed exchange rate does so by either buying or selling its own currency on the open market.
This places greater demand on the market and causes the local currency to become stronger, hopefully back to its intended value.
This was the method employed by the Chinese government to maintain a currency peg or tightly banded float against the US dollar.
Currency boards are considered hard pegs as they allow central banks to cope with shocks to money demand without running out of reserves.
In 1973, the currencies of the European Economic Community countries, Belgium, France, Germany, Italy, Luxemburg and the Netherlands, participated in an arrangement called the Snake.
During the next 6 years, this agreement allowed the currencies of the participating countries to fluctuate within a band of plus or minus 2¼% around pre-announced central rates.
[18] Around this time, in 1990, the EU introduced the Economic and Monetary Union (EMU), as an umbrella term for the group of policies aimed at converging the economies of member states of the European Union over three phases [22] In 1963, the Thai government established the Exchange Equalization Fund (EEF) with the purpose of playing a role in stabilizing exchange rate movements.
For instance, by using reflationary tools to set the economy growing faster (by decreasing taxes and injecting more money in the market), the government risks running into a trade deficit.
This might occur as the purchasing power of a common household increases along with inflation, thus making imports relatively cheaper.
[citation needed] Additionally, the stubbornness of a government in defending a fixed exchange rate when in a trade deficit will force it to use deflationary measures (increased taxation and reduced availability of money), which can lead to unemployment.
[citation needed] The belief that the fixed exchange rate regime brings with it stability is only partly true, since speculative attacks tend to target currencies with fixed exchange rate regimes, and in fact, the stability of the economic system is maintained mainly through capital control.
