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.

A pegged exchange rate, also known as a fixed exchange rate, is where the currency of one country is tied to a usually stronger currency, such as the euro, US dollar or pound sterling.

What Does Pegging Mean? When countries participate in international trade, they need to ensure the value of their currency remains relatively stable. Pegging is a way for countries to do that. When a currency is pegged, or fixed, it is tied to another country’s currency.

The yuan was pegged to the greenback at 8.28 to the dollar for more than a decade starting in 1994. Because the yuan would appreciate significantly against the greenback if it were allowed to float freely, China caps its rise by buying dollars and selling yuan.

Key Takeaways. By pegging its currency, a country can gain comparative trading advantages while protecting its own economic interests. A pegged rate, or fixed exchange rate, can keep a country’s exchange rate low, helping with exports. Conversely, pegged rates can sometimes lead to higher long-term inflation.

Among the disadvantages is the large amount of reserves a central bank has to maintain to make a pegged exchange rate work. Those large reserves can spark higher inflation, which causes prices to rise, creating problems for a country’s economic stability.

The purpose of a fixed exchange rate system is to keep a currency’s value within a narrow band. Fixed exchange rates provide greater certainty for exporters and importers and help the government maintain low inflation.

A fixed exchange rate helps to ensure the smooth flow of money from one country to another. It helps smaller and less developed countries to attract foreign investment. It also helps the smaller countries to avoid devaluation. Many countries that operate of their currency and keep inflation stable.

Higher interest rates offer lenders in an economy a higher return relative to other countries. Therefore, higher interest rates attract foreign capital and cause the exchange rate to rise.

If monetary policy or fiscal policy impacts the price level, that country’s relative price level is higher relative to other countries, making its goods more expensive. This leads to a decrease in the demand for that currency, and therefore a depreciation of that currency.

These are the most common foreign exchange controls:

1. Banning or limiting purchases of foreign currency within the country.
2. Banning or restricting the use of foreign currency within the country.
3. Setting exchange rates (instead of letting the value of the currency fluctuate according to market forces)

2. Full Fledged System of Exchange Control: Under this system, the Government does not only Peg the Rate of Exchange but have complete control over the entire foreign exchange transactions. All receipts from exports and other transactions are surrendered to the control authority i.e., Reserve Bank of India.

Exchange controls are government-imposed limitations on the purchase and/or sale of currencies. These controls allow countries to better stabilize their economies by limiting in-flows and out-flows of currency, which can create exchange rate volatility.