How do currency pegs affect national monetary policy?

A currency peg fixes a country’s exchange rate to another currency or basket, trading flexible exchange rates and independent domestic monetary policy for stability in prices and trade terms. Robert Mundell Columbia University identified this trade-off more formally as the policy trilemma: a country cannot simultaneously maintain a fixed exchange rate, free capital mobility, and an independent monetary policy. The immediate effect of a peg is to force central banks to align domestic interest rates and liquidity with those of the anchor currency to preserve the parity.

Policy trade-offs and the impossible trinity

Maintaining a peg requires active management of monetary variables. Maurice Obstfeld at the International Monetary Fund explains that defending a peg often means buying or selling foreign exchange reserves, adjusting short-term interest rates to deter capital flows, and occasionally imposing capital controls. When external shocks hit, such as terms-of-trade swings or sudden reversals in capital flows, the central bank’s room to counteract inflation or stimulate growth is constrained because deviating from the anchor’s policy risks breaking the peg. This constraint can discipline inflation expectations when anchor currency policy is stable, but it also transmits inflation or deflation from the anchor country into the pegging economy.

The costs of this constraint show up in financial stability and crisis risk. Carmen Reinhart Harvard University and Kenneth Rogoff Harvard University document that fixed exchange regimes can be vulnerable to sudden stops and speculative attacks when fiscal imbalances, weak banking systems, or low reserves undermine credibility. If markets expect a devaluation, capital flight can force a rapid policy shift that entails sharp interest rate moves, abrupt currency depreciation, and painful adjustments in wages and prices. Conversely, well-managed pegs with ample foreign reserves and credible institutions can provide long-run price stability and predictability for trade and investment.

Consequences for communities and territory

The monetary limits of a peg have tangible human and territorial consequences. Regions dependent on exports priced in the anchor currency may gain predictability that supports jobs and investment in ports, factories, and agricultural supply chains. At the same time, regions dependent on domestic-demand sectors may suffer when the central bank cannot lower interest rates to cushion a recession. Historical episodes show that a loss of monetary flexibility can translate into prolonged unemployment, fiscal austerity, and social stress in cities and rural areas alike. Territory matters as border economies and dollarized trade corridors react differently to a peg than inland, non-tradable sectors.

Policy design therefore requires balancing credibility, reserve buffers, and institutional capacity. Countries with deep, integrated financial systems and credible fiscal frameworks can often exploit pegs to anchor inflation expectations. Those with volatile capital flows, limited reserves, or weak policy institutions face higher risks of abrupt correction. Understanding how a peg reshapes the policy toolkit helps explain why some countries choose tightly managed pegs, why others float, and why the same choice can produce very different social and economic outcomes across regions.