What Is a Currency Peg?

A currency peg is a policy in which a national government sets a specific fixed exchange rate for its currency with a foreign currency or a basket of currencies. Pegging a currency stabilizes the exchange rate between countries. Doing so provides long-term predictability of exchange rates for business planning. However, a currency peg can be challenging to maintain and distort markets if it is too far removed from the natural market price.

A currency peg is a nation's governmental policy whereby its exchange rate with another country is fixed. Most nations peg their currencies to encourage trade and foreign investments, as well as hedge inflation. When executed well, pegged currencies can increase trade and incomes. When executed poorly, nations often realize trade deficits, increased inflation, and low consumption rates. 

How Does a Currency Peg Work?

The primary motivation for currency pegs is to encourage trade between countries by reducing foreign exchange risk. Profit margins for many businesses are low, so a small shift in exchange rates can eliminate profits and force firms to find new suppliers. That is particularly true in the highly competitive retail industry.

Countries commonly establish a currency peg with a stronger or more developed economy so that domestic companies can access broader markets with less risk. The U.S. dollar, the euro, and gold have historically been popular choices. Currency pegs create stability between trading partners and can remain in place for decades. For example, the Hong Kong dollar has been pegged to the U.S. dollar since 1983.

Only realistic currency pegs aimed at reducing volatility can produce economic benefits. Setting a currency peg artificially high or low creates imbalances that ultimately harm all countries involved.

Source: Investopedia