Currency Peg

You travel to Bermuda. You’re an American. USD is your jam. Bermuda operates on the Bermuda dollar. You find out that, for every $1 you have in U.S. dollars, you receive $1 in Bermuda dollars. Bermuda’s currency is “pegged” to the U.S. dollar.

In this scenario, the island’s currency is fixed against the value of another currency: The U.S. dollar. In this situation, the value of Bermuda’s currency is entirely reliant on the appreciation and depreciation of the U.S. dollar.

A currency peg has its pros and cons. A currency peg stabilizes one currency by linking to what is perceived to be more stable, and has a higher level of international demand. Doing so also reduces volatility if the nation borrows a lot of capital in foreign currencies.

However, that peg is entirely reliant on the stability of the foreign currency. So, for example, any country that pegged its currency to the U.S. dollar was highly vulnerable to steep inflation and concerns about depreciation back in 2011, when the U.S. government nearly defaulted on its debt. Bermuda had no control over the stability of its currency by maintaining a fixed rate. Had it floated its currency instead, its currency may have appreciated during this time of instability.