Argentina Currency Peg and Fiscal Reforms

Problems in Argentina
What happened in 1973-1989
What is pegging
Why pegging
Risks of us dollar peg – adv and disadvantages
What was done as part of pegging
Outcomes
Analysis of outcomes
Effects of fiscal policy – convertibility plan

What is Argentina going through?

What is a Currency Peg?

A currency peg is a policy in which a national government sets a specific fixed exchange rate for its
currency with a foreign currency or basket of currencies. A currency peg can reduce uncertainty,
promote trade, and boost economies. An overly low currency peg keeps domestic living standards
low, hurts foreign businesses, and creates trade tensions among countries. An artificially high
currency peg contributes to the overconsumption of imports and often causes inflation when it
collapses.

Only realistic currency pegs aimed at reducing volatility can produce economic benefits. Setting a
currency peg artificially high or low creates imbalances that ultimately harm all countries involved.

Advantages of a Currency Peg 

Pegged currencies can expand trade and boost real incomes, particularly when currency
fluctuations are relatively low and foresee no long-term changes. Without exchange rate risk
and tariffs, individuals, businesses, and nations are free to benefit fully from specialization and
exchange.

With fixed exchange rates and within a mutually beneficial economic framework, farmers may be
able to effectively produce, technology firms may be able to expand research and development,
and retailers will be able to source from efficient producers.

Pegging allows for long-term investments in other countries as fluctuating exchange rates are not
disrupting supply chains and altering the value of investments.

Disadvantages of a Currency Peg 

The central bank of a country with a currency peg must monitor and manage cash flow and avoid
spikes in a currency's supply and demand. These spikes can require a central bank to hold
large foreign exchange reserves to counter excessive buying or selling of its currency. Currency pegs
affect forex trading by artificially stemming volatility.

When a currency is pegged at an excessively low exchange rate, domestic consumers will be
deprived of the purchasing power to buy foreign goods. If the Chinese yuan is pegged too low
against the U.S. dollar, Chinese consumers will have to pay more for imported food and oil,
lowering their consumption and affecting their standard of living. The sellers, U.S. farmers, and
Middle East oil producers, see a decrease in demand, and business loss and trade tensions may
escalate among the countries.

If a currency is pegged at an overly high rate, a country may be unable to defend the peg over time.
Domestic consumers may buy too many imports and drive up demand. Chronic trade deficits create
downward pressure on the home currency, forcing the government to spend foreign exchange
reserves to defend the peg. If government reserves are exhausted, the peg will collapse.

As a currency peg collapses, the country that set the peg high will find imports more expensive.
Inflation will rise, and the nation may have difficulty paying its debts. The other country will find its
exporters losing markets, and its investors losing money on foreign assets that are no longer worth
as much in domestic currency. Major currency peg breakdowns include the Argentine peso to the
U.S. dollar in 2002, the British pound to the German mark in 1992, and arguably the U.S. dollar to
gold in 1971.

Pros
 Expands trade and boosts real incomes
 Makes long-term investments realistic
 Reduces disruptions to supply chains
 Minimizes changes to the value of investments

Cons
 Affects forex trading by artificially stemming volatility
 Erodes purchasing power when pegged too low
 Creates trade deficits when pegged too high
 Increases inflation when pegged too high