Adjustable peg

What Is Adjustable Peg?

An adjustable peg is a type of exchange rate regime in the field of International Monetary Policy where a country's currency is fixed, or "pegged," to another currency or a basket of currencies, but with the flexibility to adjust the peg's value under specific conditions. This hybrid system aims to combine the stability of a fixed exchange rate with the adaptability of a floating exchange rate. The primary goal of an adjustable peg system is to maintain a relatively stable exchange rate while allowing for periodic changes to address fundamental economic imbalances. A nation's central bank typically manages the adjustable peg by intervening in the foreign exchange market.

History and Origin

The adjustable peg system gained prominence as a cornerstone of the Bretton Woods System, established in 1944. Following World War II, representatives from 44 Allied nations convened in Bretton Woods, New Hampshire, to devise a new international monetary order aimed at fostering monetary cooperation and stability, and preventing the competitive devaluations that contributed to the economic turmoil of the 1930s. The system designated the U.S. dollar as the world's primary reserve currency, which was itself fixed to gold at a rate of $35 per ounce. Other member countries then pegged their currencies to the U.S. dollar within a narrow band (typically ±1%). This structure allowed for stable exchange rates crucial for post-war reconstruction and trade, yet it included provisions for countries to devalue or revalue their currencies in response to fundamental disequilibrium in their balance of payments, subject to the approval of the International Monetary Fund (IMF). ¹⁶The Bretton Woods system was designed to offer stability while avoiding the rigidity of earlier systems like the classical gold standard.
¹⁵

Key Takeaways

• An adjustable peg combines features of both fixed and floating exchange rate systems.
• It provides exchange rate stability while allowing for adjustments to address economic fundamentals.
• The Bretton Woods System was the most prominent historical example of an adjustable peg regime.
• Maintenance often requires a central bank to hold significant foreign reserves and conduct market interventions.
• Adjustments to the peg typically require international approval, such as from the IMF.

Interpreting the Adjustable Peg

Under an adjustable peg system, the stability of the pegged currency is paramount for international trade and investment. When a country adopts an adjustable peg, it signals a commitment to a predictable exchange rate, which can enhance investor confidence and reduce currency risk for businesses engaged in cross-border transactions. However, the "adjustable" aspect implies that the fixed rate is not absolute or permanent. Interpretation centers on whether the current peg remains appropriate given a country's economic performance, such as its trade balance and inflation differential compared to its anchor currency.

A sustained surplus or deficit in the balance of payments might indicate a "fundamental disequilibrium," signaling that the existing peg is no longer sustainable and a readjustment is needed. For example, persistent balance of payments deficits might suggest that the currency is overvalued, making exports expensive and imports cheap, thus necessitating a devaluation. Conversely, persistent surpluses might suggest undervaluation, potentially leading to a revaluation. The legitimacy and timing of these adjustments, often involving the IMF during the Bretton Woods era, were critical for the system's smooth functioning.

Hypothetical Example

Consider a hypothetical country, "Economia," which has pegged its currency, the "Econo" (ECO), to the U.S. dollar at a rate of ECO 10 = USD 1. Economia's central bank maintains this adjustable peg by buying or selling U.S. dollars in the foreign exchange market.

• Scenario 1: Pressure to Devalue
  Economia experiences several years of high domestic inflation relative to the U.S. This makes Economia's exports more expensive and imports cheaper for international buyers. As a result, Economia's balance of payments moves into a persistent deficit, and the central bank's foreign reserves begin to deplete rapidly as it sells U.S. dollars to prop up the Econo. To correct this "fundamental disequilibrium" and restore economic equilibrium without completely exhausting its reserves, Economia's government decides to adjust its peg. After consultation and approval, the central bank devalues the Econo, changing the peg to ECO 12 = USD 1. This makes Economia's exports more competitive and imports more expensive, helping to reduce the trade deficit and ease pressure on its reserves.

• Scenario 2: Pressure to Revalue
  Alternatively, suppose Economia experiences strong economic growth and consistently large trade surpluses, leading to an accumulation of foreign reserves. Speculators begin to anticipate a revaluation of the Econo, prompting capital controls or large inflows of foreign currency hoping to profit from the appreciation. To prevent excessive inflationary pressures from the surplus and to avoid becoming too expensive for its trading partners, Economia's government might choose to revalue the Econo, adjusting the peg to ECO 8 = USD 1.

Practical Applications

While the pure adjustable peg system, as exemplified by Bretton Woods, is no longer the dominant international monetary arrangement, its principles influence contemporary monetary policy and exchange rate management. Many countries today operate under variations of pegged systems or "managed floats," where the central bank intervenes to influence the exchange rate without a strictly fixed target. The International Monetary Fund (IMF) continues to monitor and classify member countries' exchange rate arrangements, and its data provides insights into how various regimes function globally.,¹⁴,^{13 12}Understanding the adjustable peg is crucial for analyzing historical financial events and for appreciating the spectrum of exchange rate policies that exist, from rigidly fixed to freely floating. Central banks still adjust interest rates or intervene in currency markets to steer their currencies, reflecting a practical application of flexibility within exchange rate management.

Limitations and Criticisms

Despite its initial success in providing post-war stability, the adjustable peg system, particularly under Bretton Woods, faced significant challenges and ultimately collapsed in the early 1970s. ¹¹A major criticism was the inherent conflict between maintaining fixed exchange rates and allowing countries to pursue independent monetary policies. This "trilemma" (also known as the impossible trinity) suggests that a country can only achieve two of the following three goals simultaneously: a fixed exchange rate, free capital mobility, and an independent monetary policy. Under the adjustable peg, nations often sacrificed monetary policy autonomy to defend their currency's peg.,¹⁰

Furthermore, the system was vulnerable to speculative attacks. If market participants believed a currency was significantly overvalued or undervalued and anticipated an adjustment to the peg, they could initiate massive capital flows to profit from the expected change, putting immense pressure on the central bank's foreign reserves. This often forced the authorities into devaluing or revaluing under duress, rather than in an orderly fashion.,^{9 8}The system also struggled with liquidity issues and the "Triffin dilemma," where the reserve currency country (the U.S. dollar) had to run deficits to supply enough international reserves, which eventually undermined confidence in its convertibility to gold.
⁷

Adjustable Peg vs. Managed Float

The adjustable peg and the managed float are both hybrid exchange rate regimes that fall between strictly fixed and purely floating systems. However, they differ in their degree of flexibility and the nature of intervention.

While an adjustable peg involves a formal commitment to a specific rate that is only changed through a deliberate, often politically significant, decision, a managed float (sometimes called a "dirty float") allows the exchange rate to fluctuate primarily based on market supply and demand.,^{6 5}Under a managed float, the central bank intervenes periodically to influence the direction or reduce the volatility of the currency, rather than defending a precise, published peg.,⁴,³ This makes the managed float generally more flexible and less prone to the sudden, large-scale crises that can plague adjustable pegs if adjustments are delayed.

FAQs

What does "pegged but adjustable" mean?

"Pegged but adjustable" means that a country's currency value is officially linked to another currency (or a basket) at a set rate, similar to a fixed exchange rate. However, unlike a truly fixed rate, this peg can be changed or adjusted by the monetary authorities if economic conditions warrant it, typically to address a fundamental imbalance in the country's balance of payments.

Why did the adjustable peg system of Bretton Woods collapse?

The Bretton Woods adjustable peg system collapsed primarily due to persistent U.S. balance of payments deficits and a loss of confidence in the U.S. dollar's convertibility to gold.,^{2 1}Other factors included the inflexibility of the system to respond to diverging economic policies among member countries, and increasing speculative capital flows that put immense pressure on national currencies, forcing difficult choices between defending the peg and pursuing domestic monetary policy goals.

Is the adjustable peg still used today?

The original adjustable peg system, as implemented under Bretton Woods, is no longer in widespread use as the dominant international monetary system. Most major economies now operate under floating exchange rate or managed float regimes. However, some countries maintain various forms of pegs or bands for their currencies, and the concept of a periodically adjustable peg influences how central banks approach currency management.