In one sentence
An adjustable peg is a “fixed-but-adjustable” exchange-rate regime: the central bank keeps the currency near a declared par value most of the time, but it may realign (devalue/revalue) the peg when fundamentals or balance-of-payments pressures make the old parity unsustainable.
How it works
To maintain the peg, the central bank (or monetary authority) typically:
- intervenes in FX markets using reserves (buying/selling foreign currency),
- adjusts domestic interest rates to influence capital flows,
- may use capital controls or prudential tools to reduce volatile flows.
The “adjustable” part is that the par value can be changed—usually infrequently—when the peg becomes too costly to defend.
The macro constraint: the policy trilemma
With high capital mobility, a country cannot simultaneously have:
- a fixed exchange rate, 2) independent monetary policy, and 3) free capital flows.
flowchart TD
A["Choose two (trilemma)"] --> B["Fixed exchange rate"]
A --> C["Independent monetary policy"]
A --> D["Free capital mobility"]
B --> D --> E["Then monetary policy is constrained<br/>(rate follows anchor)"]
B --> C --> F["Then capital controls or frictions needed"]
C --> D --> G["Then exchange rate must float"]
An adjustable peg is often an attempt to live “near” the fixed-rate corner while retaining some room for domestic stabilization, especially by allowing occasional realignments.
Why pegs break: expectations and speculative pressure
If markets believe a devaluation is coming, they try to sell the currency before it happens. Defending the peg then forces the central bank to burn reserves and/or raise interest rates, which can damage the domestic economy.
Uncovered interest parity gives a useful intuition:
$$ i \approx i^* + \mathbb{E}[\Delta s] + \rho $$
where $i$ is the domestic interest rate, $i^*$ the foreign rate, $\mathbb{E}[\Delta s]$ expected depreciation, and $\rho$ a risk premium. If a devaluation is expected ($\mathbb{E}[\Delta s]>0$), keeping capital from leaving can require a higher $i$.
flowchart LR
A["Peg looks overvalued<br/>(reserves falling, current account deficit)"] --> B["Expectations of devaluation"]
B --> C["Capital outflow / FX demand"]
C --> D["Reserve loss + rate hikes"]
D --> E{"Defend or realign?"}
E -- "Defend" --> F["High rates, recession risk"]
E -- "Realign" --> G["Devaluation/revaluation<br/>(new parity)"]
Bretton Woods as the classic example
The Bretton Woods system (1944–early 1970s) combined capital controls with par values that could be adjusted. It delivered exchange-rate stability for trade but ultimately struggled under divergent inflation rates, large capital flows, and pressures on the U.S. dollar–gold link.
Related Terms with Definitions
- Bretton Woods System: The post-World War II framework for international monetary policy that established fixed but adjustable exchange rates.
- Speculation: Trading on the expectation of future changes in an asset’s price, including currencies.
- Par Value (Exchange Rate Parity): The declared value of a currency against an anchor currency or commodity standard.
- Foreign Exchange Market: The global marketplace for buying and selling national currencies.
- Impossible Trinity (Trilemma): The constraint that you can choose only two of fixed exchange rates, free capital flows, and independent monetary policy.