The Basics
- Simple definition: An exchange rate system where a currency’s value is tied to another currency or a basket at a specific rate, maintained by central bank intervention.
- Core idea: The government promises to buy and sell its currency at a fixed price indefinitely.
- Think of it as: A price tag on your currency that does not change.
What It Actually Means
Under fixed rates, the central bank stands ready to exchange domestic currency for the anchor currency at the official rate. If market pressure pushes the rate higher, the bank sells reserves by supplying foreign currency to keep it down. If market pressure pushes the rate lower, the bank buys domestic currency using reserves. This requires large reserves and a credible commitment. Benefits include trade certainty and an inflation anchor. Costs include the loss of independent monetary policy and vulnerability to speculative attacks if rates become misaligned. Examples include Gulf states, Hong Kong, and Denmark.
Example
If Pakistan fixed the rupee at 280 per dollar, the State Bank would have to sell dollars whenever the rupee tried to weaken beyond 280 and buy dollars when the rupee strengthened. If reserves are insufficient, the peg collapses, as has happened many times historically.
Why It Matters (2026)
Fixed rates remain common for small open economies seeking stability, but they require discipline. Pakistan’s history of failed pegs explains why it currently uses a float.
See also
Exchange Rate Regimes • Currency Peg • Currency Board • Speculative Attack • Reserves
Read more about this with MASEconomics: