Question

Some developing countries have attempted to keep their exchange rates fixed against the U.S. dollar or other currencies, an action known as pegging. What are some disadvantages of pegging?

Answer 1

Pegging a currency limits a country's monetary policy options, risks depleting foreign reserves, and can lead to exchange rate instability due to market speculation.

Step-by-step explanation:

There are several disadvantages of pegging a currency to another, such as the U.S. dollar. One of the main disadvantages is that it limits a country's ability to use monetary policy for domestic concerns like inflation or recession, since policy must also consider the pegged exchange rate. If a country opts to use its reserves to buy and sell foreign currency to maintain the peg, this can deplete its foreign reserves and lead to potential economic vulnerability. Additionally, speculation about government intervention in the exchange rate markets might create exchange rate instability, as traders react to rumors about potential interventions. Finally, a peg often means that monetary policy is tied to maintaining the exchange rate, rather than addressing domestic economic conditions.