A fixed exchange rate, sometimes called a pegged exchange rate, is a type of exchange rate regime where a currency's value is fixed against the value of another single currency, to a basket of other currencies, or to another measure of value, such as gold.
Reasons for Fixed Exchange Rate Regimes
A fixed exchange rate is usually used to stabilize the value of a currency against the currency it is pegged to. This makes trade and investments between the two countries easier and more predictable and is especially useful for small economies in which external trade forms a large part of their GDP.
This belief that fixed rates lead to stability is only partly true, since speculative attacks tend to target currencies with fixed exchange rate regimes, and in fact, the stability of the economic system is maintained mainly through capital control. Capital controls are residency-based measures such as transaction taxes, other limits, or outright prohibitions that a nation's government can use to regulate flows from capital markets into and out of the country's capital account. A fixed exchange rate regime should be viewed as a tool in capital control.
How a Fixed Exchange Regime Works
Typically a government maintains a fixed exchange rate by either buying or selling its own currency on the open market. This is one reason governments maintain reserves of foreign currencies. If the exchange rate drifts too far below the desired rate, the government buys its own currency in the market using its reserves. This places greater demand on the market and pushes up the price of the currency. If the exchange rate drifts too far above the desired rate, the government sells its own currency, thus increasing its foreign reserves.
Another, method of maintaining a fixed exchange rate is by simply making it illegal to trade currency at any other rate. This method is rarely used because it is difficult to enforce and often leads to a black market in foreign currency. Some countries, such as China in the 1990s, are highly successful at using this method due to government monopolies over all money conversion. China used this method against the U.S. dollar .
PRC Flag
China is well-known for its fixed exchange rate. It was one of the few countries that could impose a fixed rate by making it illegal to trade its currency at any other rate.