Reference no: EM131835787

Question: One of the weaknesses of hard peg exchange rate systems is that adjustment to external shock or crisis has to occur in the real economy." Explain and discuss.

Answer to the question

If you have a sudden current account deficit, or a rise in inflation relative to your trading partners, the problem with pegged systems is that you cannot devalue much like in a soft peg system, or depreciate, like in a floating system.

• So when there is such un-competitiveness in your economy, the hard peg does not allow you to devalue or depreciate to regain competitiveness.
• Moreover, hard-peg exchange rate systems don't give you the free use of monetary policy to correct domestic imbalances.
• Interest rate would have to be set in such a way that it maintains the peg, even though when you want to do something with your interest rate, regardless of how it may affect your people in the country (interest rate is a slave to peg).
• In 1991, Argentina's peso was pegged against USD. It was fixed to 1:1
• When your currency decreases, you can actually reduce inflation. But as the Peso is pegged, it is high and uncompetitive. The only way to overcome this is a growth in productivity. You can produce more goods in a shorter amount of time, your production cost will lessen and therefore, you can sell your exports at a cheaper price, competitiveness increases
• The combination of low inflation rate (indirect result of the peg) + market liberalization (a direct effect from the government's point of view to denationalize) would lead to a rapid growth of productivity, which helps them to ease their competitiveness (the only way to become competitive)
• This happened at first, but this didn't persist due to rigid labor laws and strong union pressure (wages should have been decreased, but they didn't)
• Internal factors: High wages keep cost of production high + rising unit selling price, leading to current account deficit rise (CAD increases as exports decrease)
• External factors: Rising USD, but the biggest blow occurred when Argentina's largest trading partner, Brazilian real value was devalued (CAD increases as exports decrease)
• Argentina banks allow depositors to hold their money in either $ or peso. to show that they are serious about the peg and the exchange rates. So, it doesn't matter whether you want to hold your money in $ or Peso as it will worth exactly the same.
• The investors (Argentine people) are afraid that CAD will occur again, resulting their currency to devalue, they would keep their money in $ than in Peso.
• As people continue to convert peso into $, Peso supply increases, so government buy $ using Peso (buying domestic, selling foreign). They should have decreased the interest rate the moment this happened (As interest rate is a slave to the peg). The CB would shrink the money supply causing interest rate to rise.
• If interest rate rose on Peso deposits, people would now hopefully change back their $ to Peso and they wouldn't lose a lot of foreign currency reserves. Moreover, demand for goods decreases as people save, prices of goods decrease, wages would decrease, enter recession (external shock is borne by the real economy), prevent capital flight, exports increase, all your worries about hyperinflation (CAD) will disappear, and you'll get a stable economy again.

I dont understand the ;as 2nd to last dot points saying "the government should have decreased interest rates (As interest rate is a slave to the peg). argent is hard pegged to the US doesn't this mean that the US government controls the interest rate (the currency it is pegged to ) the Argentinian government cant decrease interest rates and how exactly does this help it says the CB would shrink the money supply to get int erst rates interest rates need to go down to go up?