Economics Buffet: Currency Pegs in 5 Minutes

Currency pegs are one of the basics of understanding how currencies interact with each other. The most notable of these is the gold standard. Everyone pegged the worth of their currency to how much gold they kept in reserve, leaving merchants to do what they did best and facilitated trade with terms everyone could understand and rely on. It created a simple system that helped to increase international trade. 

Definition of 'Currency Peg'

A country or government's exchange-rate policy of pegging the central bank's rate of exchange to another country's currency. Currency has sometimes also been pegged to the price of gold. 

Also known as a "fixed exchange rate" or "pegged exchage rate." 

However, now that we've move away from the gold standard, currency pegs can be more confusing and carry many political and trade ramifications with them. Here is the (very) quick and dirty on what an overvalued or undervalued currency peg may mean and some famous examples. Click on the linked text for source documents. 

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Undervalued Currency Peg

China pegged their currency against the US dollar in a fixed exchange rate. With currency markedly low, this opened up Chinese exporting to a very large scale and audience, allowing China’s economy to grow at a remarkable pace. This has caused complaints from foreign competitors that they lose business due to the low prices of Chinese goods. However, many other foreign businesses have profited from the low cost of good and through them consumers have gained as well.

A 2011 article in Reuter’s claimed: The department said it concluded China did not meet the U.S. legal definition of a currency manipulator due to the appreciation of its currency -- known as the yuan or renminbi -- since June 2010 and recent Chinese statements that it would continue to promote exchange rate flexibility.

It did not escape these accusations in 1992 or 1994 when the US did give them a currency manipulator label, making them one of the last countries to receive that label more than 18 years ago. As of April 2013, the renminbi hit a record high against the dollar, yet their currency is still significantly undervalued and they are under political pressure to rectify this. With Chinese currency appreciating, the cost of their goods is expected to rise and they may lose an advantage to their exporting sector. With costs of exports rising, it is also affecting importers of good with increased prices. More flexible currency exchange would start to position the renminbi as a true world currency given the growing strength of the Chinese economy which will have a number of unknown affects for global trade and policy.

Overvalued Currency Peg

An overvalued currency is one where the exchange rate is higher than others. A strong currency reduces the appeal of exporting to other countries due to goods being more expensive. However, it lowers the cost of imports allowing people to benefit from a strong currency to gain access to foreign products at attractive prices. Domestic demand for certain goods might be lower due to the consumer cost being higher than comparable imports, again giving the advantage to foreign firms at the expense of domestic companies. There is a conflict at times between people who want a strong currency, yet also want their local businesses to thrive. Many times, these two things cannot coexist. 

An example of a developed country currently suffering ill effects is Australia. Right now the Australian dollar is seen to be one of the most overvalued in the world. When hard economic times hit, it is harder to recover with such a strong dollar. Australia is starting to take action to depreciate their dollar to come more in line with international standards (Greber, 2013). By doing so, they will be able to increase internal growth and hopefully bolster their slowly struggling economy.