Fixed Exchange Rate
What it is:
How it works/Example:
There are generally two ways in which countries can value their currency in the world market. They can either fix their currency to gold or to another major currency, like the U.S. dollar or the euro. Alternatively, they can let their currency float in the world market.
If the exchange rate is fixed, the country’s central bank, or its equivalent, will set and maintain an official exchange rate. To keep this local exchange rate tied to the pegged currency, the bank will buy and sell its own currency on the foreign exchange market in order to balance supply and demand.
Why it matters:
In order to maintain this fixed exchange rate, the central bank must maintain a high level of currency reserves.
The existence and argument for these types of fixed rates is that the fixed exchange rate facilitates trade and investment between the two countries with the pegged currencies. It can be especially beneficial for the smaller country, which depends more heavily on international trade.
A fixed exchange rate also has its weaknesses; once pegged to a larger country’s currency, the smaller country can lose some control over its domestic monetary policy.