Pegging is a financial policy which connects the value of one country’s currency to the value of the currency of another currency. This comparative system was initially put in place after World War II. Called the Bretton Woods system, for the location in which it was negotiated, it established rules for financial and commercial relationships between the major industrial states of the world.
The system was set up during a meeting of all Allied nations with the purpose of setting up rules, institutions and policies with which to regulate the international monetary system, establishing the still active International Monetary Fund and the World Bank. Among the goals of the arrangement was an obligation for each country to work within the new policy, tying world currency to the U.S. dollar so as to accommodate imbalances in payments.
While originally the U.S. dollar was backed by gold, in 1971 that connection was severed, making the dollar a ‘fiat currency.’ This means that the dollar is backed by nothing more than the guarantee of the government.
When a country pegs its currency to the currency of another country, adjustments become necessary as economic conditions within either country changes. These adjustments are typically intended to improve the pegged country’s position in the export market, making it more competitive.
You might also hear the term “crawling peg”, which means the same thing. How often the rate of exchange between the two countries is altered depends upon a number of agreed upon factors such as a predetermined length of time or an upper or lower limit of value.
—
Related Articles at Investing School:
- Adjustable Rate
- What is an Absolute Rate and Why Does it Matter?
- Understanding a Balloon Mortgage
- Investment Terms