Fixed Exchange Rate

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Fixed Exchange Rate

What it is

A fixed exchange rate (or peg) is a system in which a country’s currency value is tied to another currency, a basket of currencies, or a commodity (such as gold). The peg keeps the currency’s value within a narrow band to promote price stability and predictability.

How it works

A central bank or government maintains the peg by buying or selling its currency and holding foreign-exchange reserves. Pegs can be:
* Single-currency pegs (e.g., to the U.S. dollar or euro)
* Basket pegs (weighted group of currencies)
* Commodity pegs (e.g., gold)

Key takeaways

  • Fixed rates provide certainty for importers, exporters, and investors.
  • They can help maintain low inflation and stable interest rates.
  • Fixed regimes restrict monetary policy flexibility and require substantial reserves.
  • Most major economies use floating exchange rates today.

Advantages

  • Greater predictability in international prices and trade contracts.
  • Helps anchor inflation expectations, which can lower interest rates.
  • Can reduce exchange-rate speculation in smaller or less-developed economies.

Disadvantages

  • Reduces a central bank’s ability to use interest rates for domestic stabilization.
  • Prevents automatic market corrections when a currency is over- or undervalued.
  • Requires large foreign-exchange reserves to defend the peg.
  • Risk of parallel (black‑market) exchange rates if official rates become unrealistic, which can lead to forex shortages and disruptive devaluations.

Historical context

  • Bretton Woods era (post–World War II to early 1970s): Most participating countries pegged their currencies to the U.S. dollar, which was convertible to gold. Growing U.S. balance-of-payments deficits made the system unsustainable; the U.S. left the gold standard in the early 1970s and major currencies moved to floating rates.
  • European Exchange Rate Mechanism (ERM, established 1979): A precursor to the euro that required member currencies to stay within a narrow band around a central rate. The ERM helped pave the way for the euro (official currency conversion occurred on January 1, 1999). ERM II now governs managed floats for countries preparing to adopt the euro.

Real-world example

In 2018 Iran attempted to unify disparate market and official rates by setting a fixed official rate of 42,000 rials per U.S. dollar after large intraday losses and wide gaps between the unofficial market (about 60,000 rials) and the prior official rate (~37,000).

Fixed vs. floating exchange rates

  • Fixed: Government or central bank sets and defends a specific rate or narrow band.
  • Floating: Exchange rates move according to market supply and demand with minimal direct intervention.
    The U.S. dollar is a floating currency.

Bottom line

A fixed exchange rate can provide stability and lower inflation in the short term, which benefits trade and investment. However, it constrains monetary policy, demands substantial reserves, and can create economic distortions if the peg becomes misaligned. For these reasons, most developed economies use floating exchange-rate systems.

Sources

International Monetary Fund — Exchange rate regimes; Yale Law School — Bretton Woods Agreements; U.S. Department of State (historical overview of Nixon and the end of Bretton Woods); European Parliament — History of European monetary integration; UK Parliament — The ERM and the single currency.