Principles of Macroeconomics / Unit 13 MAC 1220 worked example, 60 to 90 seconds
A Peg Away from the Market Rate
The idea
A peg set away from the equilibrium rate creates an imbalance, exactly as a price control does in unit two. Work it as a price floor or ceiling on the currency: find which side exceeds which, then say what the central bank must do to hold the peg and what that costs it.
In practice
Take the peso market priced in dollars, with equilibrium at 10 cents per peso. Peg the peso above that, at 12.5 cents. At the higher price, the quantity of pesos supplied exceeds the quantity demanded, so there is a surplus of pesos. To hold the peg the central bank must buy that surplus, and it buys with foreign reserves, which drain. Now peg below equilibrium, at 8 cents. Quantity demanded exceeds quantity supplied, so there is a shortage, and the bank must supply its own currency, accumulating foreign reserves as it does.
Where people slip
The two directions are not symmetric in what they cost. A bank holding its currency down creates its own currency, and can do so without limit, though that is inflationary. A bank holding its currency up spends reserves it has to have, so that peg has a hard stop. When traders judge the reserves are nearly gone they sell, which drains the remainder faster, and the peg then breaks suddenly rather than gradually.
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