Fixed Exchange Rate

Intermediate

A fixed exchange rate is an exchange rate system in which a government or central bank sets its currency's value at a specific rate against another currency, a group of currencies or a commodity such as gold, and acts to keep it there.

To maintain a fixed exchange rate, the central bank must stand ready to buy or sell its own currency in the foreign exchange market. If the currency weakens, it buys its own currency using reserves of foreign currency. If it strengthens, it sells its own currency.

Fixed exchange rates provide stability and predictability, which can encourage trade and investment, and help control inflation by tying the currency to a more stable one. They are often used by smaller economies that trade heavily with a larger partner.

For example, Hong Kong has linked its dollar to the US dollar since 1983, keeping it within a narrow band.

The drawbacks are significant. A country with a fixed exchange rate usually has to follow the interest rate policy of the country it is pegged to, even if that does not suit its own economy. Defending the peg requires large foreign currency reserves. If markets believe the peg cannot be sustained, speculative attacks can force a sudden devaluation, as happened in several Asian countries in 1997.

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