What is a Pegged Exchange Rate?
A pegged exchange rate, also known as a fixed exchange rate, is a type of exchange rate in which a currency's value is fixed against either the value of another country's currency or another measure of value, such as gold.
How a Pegged Exchange Rate Works
Generally, there are two ways in which countries can value their currency in the world market. They can either fix (or peg) their currency to gold or to another major currency, like the U.S. dollar or the euro. Alternatively, they can allow their currency float in the world market.
If the exchange rate is pegged, the country’s central bank, or an equivalent institution, 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 to balance supply and demand.
Why a Pegged Exchange Rate Matters
A pegged exchange rate fixes one country's currency to another country’s currency. In order to maintain a pegged exchange rate, a central bank must maintain a high level of currency reserves. The rate is beneficial in that it facilitates trade and investment between two countries with the pegged currencies. It can be especially advantageous for the smaller country, which depends more heavily on international trade.
However, a pegged 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.
