What is a fixed exchange rate?
A fixed exchange rate (also called a pegged rate) is a currency regime in which a government or central bank ties the official value of its currency to the value of another currency, to a basket of currencies, or to a commodity (for example, gold). The goal is to keep the domestic currency’s value within a narrow, predictable band so that exchange-rate risk is reduced for trade and investment.
Key takeaways
– A fixed exchange rate pins a currency’s value to an external anchor (another currency, a basket, or a commodity) and constrains market-driven fluctuations.
– Fixed regimes can stabilise prices and trade but require large foreign-exchange reserves and limit independent monetary policy.
– Many advanced economies moved to floating rates in the early 1970s; several developing economies still use pegs or managed arrangements.
– Real-world historical examples include the Bretton Woods system (pegs to the U.S. dollar/gold) and the European Exchange Rate Mechanism (ERM) that preceded the euro. A recent illustrative example is Iran’s 2018 decision to set an official rial-to-dollar rate (creating a policy response to wide gaps between official and market rates). (Sources: Investopedia; IMF; Yale Law School; U.S. Dept. of State; European Parliament; BBC)
Understanding fixed exchange rates
How it works
– The central bank sets a target exchange rate (or a narrow band) relative to the chosen anchor.
– To maintain the peg, the central bank buys or sells foreign currency and adjusts domestic liquidity—using foreign-exchange reserves and open-market operations—to offset market pressures.
– Monetary policy is constrained: if the peg requires defending, the central bank may have to align interest rates with those of the anchor currency’s country and prioritize reserve stability over domestic macro objectives.
Purposes and benefits
– Exchange-rate stability: predictable currency values reduce transaction and hedging costs for exporters, importers, and investors.
– Low inflation anchor: by tying the currency to a low-inflation anchor, a country can import price stability and help keep long-term interest rates lower.
– Reduced speculation (if credible): a credible peg can discourage destabilising currency bets.
Historical context
– Bretton Woods (post-World War II to early 1970s): Participating countries fixed their currencies to the U.S. dollar, while the dollar was convertible to gold. Structural imbalances and U.S. deficits led to strains; the system ended in the early 1970s when the U.S. left the gold standard. (Sources: Yale Law School; U.S. Dept. of State)
– ERM and the euro: The European Exchange Rate Mechanism (established 1979) was a precursor to monetary union; members agreed to keep currencies within a tight band of a central rate. The ERM experience informed the later adoption of the euro. (Sources: European Parliament; UK Parliament)
– Contemporary practice: Most major industrial nations use floating rates today; some developing countries maintain pegs to limit volatility and encourage trade. (Source: Investopedia; IMF)
Advantages of fixed exchange rates
– Greater certainty for international trade and investment.
– Can support low inflation and help anchor expectations.
– May reduce currency speculation when credibility is high.
Disadvantages and risks
– Loss of independent monetary policy: monetary conditions must be managed to defend the peg rather than to target domestic output or employment.
– Need for large foreign-exchange reserves: defending a peg in the face of selling pressure consumes reserves.
– Vulnerability to external shocks and speculative attacks if the peg is seen as unrealistic.
– Risk of parallel (black) markets or capital flight if official and market rates diverge, potentially leading to disruptive devaluations. (Source: Investopedia)
Real-world examples
– Bretton Woods: a multilateral peg system anchored to the U.S. dollar/gold (mid-1940s–early 1970s). (Sources: Yale Law School; U.S. Dept. of State)
– European ERM: guided exchange-rate stability among European countries before the euro. (Sources: European Parliament; UK Parliament)
– Iran (2018): government set an official exchange rate in response to large divergences between market and official rates—illustrating how a government can use an official peg to try to reduce market fragmentation, but also how such moves can reflect and create economic stress. (Source: BBC)
Fixed vs. floating exchange rates — main differences
– Determination: Fixed = official policy sets the rate; Floating = rate set by market supply and demand.
– Policy flexibility: Fixed = limited independent monetary policy; Floating = central bank can target domestic objectives more freely.
– Stability vs. adjustment: Fixed = greater short-run stability but less capacity for automatic correction of external imbalances; Floating = more exchange-rate volatility but easier automatic adjustment.
Is the U.S. dollar a floating currency?
Yes. The U.S. dollar is a floating currency: its exchange rate versus other currencies is primarily determined by market supply and demand. Most major developed economies follow floating regimes. (Source: Investopedia)
Practical steps — for policymakers who choose a fixed exchange rate
1. Choose the anchor and band
– Decide whether to peg to a single currency, a basket, or a commodity; set the band (hard peg vs. adjustable peg).
2. Build credible foreign-exchange reserves
– Accumulate adequate reserves to defend the peg against speculative attacks and temporary imbalances.
3. Align monetary and fiscal policy
– Pursue fiscal discipline and coordinate monetary policy so interest rates and liquidity conditions do not systematically undermine the peg.
4. Establish clear intervention rules and transparency
– Publish rules for intervention, regular reserve reports, and communicate clearly to build credibility.
5. Use complementary tools
– Consider temporary capital controls or macroprudential measures if short-term pressures threaten stability.
6. Prepare contingency plans
– Have contingency options (gradual realignment, temporary capital controls, swap lines, or IMF assistance) and communicate them to markets to reduce panic during stress.
7. Monitor fundamentals continuously
– Track current-account balances, external debt, reserve adequacy, inflation differentials, and political risks that could affect the peg’s sustainability. (Sources: Investopedia; IMF)
Practical steps — for businesses that operate across currencies
1. Invoice strategically
– Invoice in the anchor currency where possible to reduce exchange-rate risk.
2. Hedge currency exposure
– Use forwards, futures, options or natural hedges (matching currency cash flows) to manage currency risk.
3. Keep FX liquidity
– Maintain working capital in relevant currencies to manage short-term mismatches and payment obligations.
4. Monitor policy signals
– Stay informed about central-bank statements, reserve levels, and any announced policy or capital-controls changes.
5. Plan for parallel-rate risks
– If there’s a history of dual official/black-market rates, build contingency plans for access to hard currency. (Source: Investopedia)
Practical steps — for investors assessing countries with pegs
1. Check reserve adequacy and trend
– Low or falling reserves relative to short-term debt and import needs increases devaluation risk.
2. Assess external balances and fiscal health
– Large current-account deficits, rising external debt, or fiscal slippage can weaken a peg’s sustainability.
3. Gauge credibility and institutional strength
– Strong, independent central banks and credible fiscal commitments reduce the risk of sudden policy shifts.
4. Watch parallel markets and capital controls
– Large gaps between official and market rates or sudden imposition of controls signal elevated risk.
5. Use hedges and position size limits
– Hedge currency exposure and size positions to limit losses from a potential devaluation or regime change.
How central banks defend a peg (typical toolkit)
– Direct intervention: buying/selling foreign reserves to offset market flows.
– Interest-rate adjustments: raising rates to deter capital outflows (but costly for domestic growth).
– Capital controls: restricting currency movements to reduce outflows in crisis.
– Revaluation/devaluation: if misalignment is clear, the official parity can be adjusted.
– External assistance: swap lines or IMF programs can provide additional liquidity. (Source: Investopedia; IMF)
The bottom line
A fixed exchange-rate regime can deliver predictability, lower inflation expectations, and trade facilitation, but those benefits come at the cost of monetary-policy flexibility and require strong commitment and sufficient reserves. Pegs are most effective when underpinned by credible institutions, prudent fiscal policy, and transparent communication. Because of these trade-offs, most advanced economies use floating rates today; fixed regimes remain an important option for some emerging and smaller economies seeking exchange-rate stability.
Further reading / sources
– Investopedia — “Fixed Exchange Rate”
– International Monetary Fund — “Exchange Rate Regimes in an Increasingly Integrated World Economy”
– Yale Law School — “Bretton Woods Agreements”
– U.S. Department of State, Office of the Historian — “Nixon and the End of the Bretton Woods System, 1971–1973”
– European Parliament — “A History of European Monetary Integration”
– BBC News — coverage of Iran’s 2018 exchange rate decision
If you’d like, I can:
– Create a decision checklist a policy team could use before adopting or breaking a peg.
– Build a one-page guide businesses can use to manage FX risk under a peg.
– Analyze a specific country to estimate the sustainability of its peg (using public data).