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How is One Currency Pegged to Another and How Does it Work?

There are several ways in which one currency can be pegged to another, and the specific details of how the peg is established and maintained can vary depending on the specific circumstances and exchange rate system being used.

One way in which a currency can be pegged to another is through a fixed exchange rate system, in which the value of the pegged currency is set at a specific level and is not allowed to fluctuate. To maintain this fixed exchange rate, the central bank or other regulatory authority in the country whose currency is pegged will intervene in the foreign exchange market by buying or selling the pegged currency as needed to maintain the desired exchange rate. This can involve buying or selling the pegged currency with the currency to which it is pegged, or with other currencies.

Another way in which a currency can be pegged to another is through a flexible exchange rate system, in which the pegged currency is allowed to fluctuate within a certain range around the fixed exchange rate. In this case, the central bank or other regulatory authority may still intervene in the foreign exchange market to maintain the exchange rate within the desired range, but it may also allow the exchange rate to fluctuate to some extent in response to market forces.

It’s worth noting that pegging a currency to another can have both benefits and drawbacks. On the one hand, it can help to stabilize the value of the pegged currency and reduce exchange rate risk for businesses and individuals. On the other hand, it can also restrict the central bank’s ability to use monetary policy to manage the economy and may not always be an effective way to address underlying economic problems.

This page was last updated on January 3, 2023.