the disadvantage is that it can induce destabilizing speculation. why is that?
In a pegged system, a smaller govt is trying to peg to lets say the dollar… Lets say the price starts to get far away from the dollar… say they are trying to peg at 10FC per $1. If it gets to 15FC per $1, speculators will begin to assume it is going back to $10. It is the smaller country’s govt who has to buy back its currency to get it to appreciate. Now the only one who wants to buy when its 15FC per $1 is the foreign govt. they have to overpay for their currency back. When they get it back to $10, the speculators may drive the price back to 15… In simple terms, a pegged exchange rate can be hard for a small local gov’t to defend against speculators (because the speculators have the advantage of knowing the gov’t wants it at a certain price)
does this senario also apply to fixed exchange rate system?
i believe it does… disadvantages of fixed are that it lacks monetary independence and it increases possible speculation regarding the revaluation of currencies… So I think they are very similar concepts.