Explain the pros and cons of a crawling peg

Question

What will be an ideal response?

Answer 1

A crawling peg involves fixing the exchange rate to a major world currency. This involves regular devaluations of a fixed amount in order to stabilize the real exchange rate in a country with higher inflation than its trading partners. Maintaining the peg requires the monetary authority to exercise discipline in the creation of new money and is anti-inflationary in that sense. Countries frequently try to reinforce the anti-inflation tendency of the crawling peg by intentionally devaluing at a slower pace than the difference between home and foreign inflation. This creates real appreciation in the exchange rate, and is intended to act as a brake on domestic inflation as foreign goods become cheaper in real terms. The use of the exchange rate in this manner has mixed success in helping control inflation, but in a number of cases it has led to severe overvaluation of the real exchange rate and increased the country's vulnerability to a crisis.
Another way in which a crawling peg exchange rate system increases a country's vulnerability to crisis is that it is sometimes politically difficult to exit from the system if it becomes overvalued. When a government announces a change in the system, it runs the risk of losing its credibility. A sudden large devaluation leads to economic losses and a loss of confidence in the country's policy makers, and thus it is common for countries to delay addressing the problem of overvaluation, so that when the correction comes, it has to be larger.