Pegging

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    Pegging is the practice of setting a fixed exchange rate between two currencies. Sometimes one currency may be pegged to a basket of other currencies.

    Pegging can help to stabilise the value of a volatile currency. Many countries peg their exchange rate to the US dollar, particularly if they have their own national dollar.

    In Europe, a number of non-eurozone countries have pegged their currency to the euro. Inside the eurozone countries pre-euro bonds remain denominated in the former currencies, such as French francs or German marks, which themselves remain pegged to each other as one means of keeping the euro stable.

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    Although the yuan no longer has a fixed rate itself, some other far eastern currencies are still pegged to China’s currency.

    Sometimes a country may peg its currency to a commodity such as gold. This was a widespread practice when the gold standard was in global use as a peg, although it is much less common now.

    Does pegging affect trading?

    Traders should pay attention to pegged currencies – where one currency is pegged very closely to another, traders are likely to see very narrow bid and ask spreads.

    Trading and making investments are smoothed when two countries enjoy pegged currencies. For smaller countries that depend on exports to boost their GDP and/or rely on imports for many essentials, pegging can make a huge difference to their economies. However, any change in fortune of the currency they have pegged to, such as the U.S. dollar, (the so-called reference value) will affect the fixed exchange rate and thus their own economy.

    Domestically, a country that has pegged its currency to another will find inflation easier to control but, conversely, will be unable to set a domestic monetary policy because of the decision to be part of a macroeconomy that offers stability.

    Countries will buy and sell their own currency on the forex markets to keep the pegged rate stable. They will buy, using their own reserves, if the rate starts to drift downwards – buying increases demand and helps push the rate upward again. Conversely, if the rate creeps above the pegged level they will sell their own currency to reduce its value and cut demand in order to level the rate again. Selling will boost a country’s reserve of foreign currencies.

    Further information

    Wikipedia article on pegging.

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