Currency Peg

Maintaining a fixed rate is an ongoing balance-sheet operation. When private demand for the domestic currency weakens, the central bank buys its own currency with foreign reserves, shrinking the monetary base unless the operation is sterilised by offsetting open-market purchases of domestic assets. When capital floods in, the reverse occurs: reserves accumulate and the base expands. Either way, the exchange rate becomes the target and the money supply becomes the residual.

This is the practical content of the policy trilemma. A country can choose at most two of a fixed exchange rate, free capital mobility and an independent monetary policy. Hard pegs with open capital accounts surrender the domestic interest rate to the anchor country; those insisting on autonomous rates must ration capital flows. Sterilisation can postpone the choice for a time, but it is bounded by the stock of domestic assets on one side and the reserve position on the other.

Fixed regimes are not a single arrangement but a gradient of commitment. At the rigid end sit dollarisation and currency boards, where domestic monetary liabilities are backed one-for-one by anchor-currency assets and the issuing authority has no discretionary lending capacity. A conventional peg is softer: the rate is fixed by policy declaration, reserves are held for defence, but the central bank retains full monetary machinery and can devalue.

Between these lie pegs with horizontal bands, where intervention is triggered only at the edges, and basket pegs, which anchor to a trade-weighted composite so no single partner's currency dominates. Crawling pegs adjust the central parity along a pre-announced path, typically to accommodate an inflation differential with the anchor, while crawling bands combine both features. Managed floats sit further along the spectrum: authorities intervene without publishing a target.

A nominal peg does not fix the real exchange rate. If domestic inflation persistently exceeds the anchor economy's, the real rate appreciates: measured qualitatively, the currency's purchasing power over foreign goods rises, exports lose competitiveness and the current account deteriorates. Financing that deficit requires capital inflows, so the peg becomes hostage to investor sentiment.

When sentiment turns, defence is expensive. The authority sells reserves and raises short-term interest rates to make speculative short positions costly, but high rates damage banks, borrowers and property markets, and markets can read that the political tolerance for pain is finite. Reserve adequacy is therefore scrutinised through import cover, the ratio of reserves to short-term external debt, and reserves relative to broad money. Once these deteriorate visibly, a self-fulfilling attack becomes rational even if the underlying fundamentals were defensible.

Expect to classify a described regime along the fixed-to-floating spectrum and to state the monetary consequence that follows. If capital is mobile and the rate is credibly fixed, the domestic policy rate must track the anchor's, and covered interest parity implies forward points close to zero when the interest differential is negligible. A persistent forward discount or a widening non-deliverable forward spread signals that markets price devaluation probability rather than pure carry.

Be ready to trace the balance-of-payments arithmetic: intervention to support the currency drains reserves and, absent sterilisation, contracts the money base and raises domestic rates. Also connect the regime to trade analysis, since a peg suppresses the automatic adjustment channel through which a depreciating currency would otherwise narrow a trade deficit, shifting the burden onto domestic prices, wages and output.