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Pegged Exchange Rates

Pegged Exchange Rates
Published:   12 Dec at 9 AM

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There are two different types of
exchange rate systems, free and pegged. A pegged system which is also
commonly referred to as a fixed system, is one that involves a fixed
exchange rate that is set and artificially maintained by the government
of that particular currency. This rate is then pegged to another nations
currency, most frequently the United States Dollar with this being the
leading currency in the world. The value of the currency, as the name
suggests, will not deviate from this set figure.

However, for a country to have a
pegged rate, they must work to keep their set rate stable. To do this,
their national or federal bank is required to maintain large reserves
of various currencies from other nations to mitigate the fluctuations
in the supply and demand. The reason for this is that if there was a
sudden increase in the demand for a particular currency which in turn
would drive up the exchange rate, the country's bank would be required
to release enough of the specified currency into the exchange market
in order to satisfy this increased demand. Similarly, they are able
to buy up currency if the demand has dropped and this is affecting the
exchange rate. For example, the US dollar value falls as more people
are looking to sell than buy, the US government may begin to buy it
to reverse this effect and in turn will drive up the value of the currency.

Generally speaking, those nations
that have more immature and potentially unstable economies are the ones
that use this pegged system for their currencies as these developing
countries frequently use this kind of system to prevent the rate of
inflation getting too extreme which could have the potential to ruin
their economy. However, whilst it has it's benefits it can also have
it's risks as well with some country's who use the pegged system,
having a currency that's real market value is not accurately reflected
by this pegged rate. It is in these scenarios that what is generally
referred to as a “black market” emerges. Black market is the name
given to the event when a currency is traded at it's true market value
and the government despite being pegged at a different value by the
country's government.

These black market's can have potentially
disastrous economic consequences for the country as people become increasingly
aware that the value of their currency doesn't match up to what the
government has set as the pegged rate. In answer to this they do the
obvious thing and quickly attempt to exchange their currency for one
more stable and established such as the Great British Pound or more
commonly the United States dollar. Unfortunately, this then has a knock-on
effect due to the earlier discussed supply and demand relation to the
exchange rate so that as the supply increases and the demand decreases,
the value plummets. So as has happened previously happened, most recently
and several african nations, if a nation fails to properly look after
their pegged rate, they will be left with a worthless currency.

« Exchange Rates - What are they and how are they calculated?

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