Pegged Exchange Rate
What it is:
The existence and argument for these types of pegged rates is that the pegged exchange rate facilitates trade and investment between the two countries with the pegged currencies. It can be especially beneficial for the smaller country, which depends more heavily on international trade.
However, a pegged exchange rate also has its weaknesses; once pegged to a larger country’s currency, the smaller country can lose some control over its domestic monetary policy.
How it works (Example):
Generally, there are two ways in which countries can value their currency in the world market. They can either fix their currency to gold or to another major currency, like the U.S. dollar or the euro. Alternatively, they can allow their currency float in the world market.
If the exchange rate is pegged, the country’s central bank, or an equivalent institution, will set and maintain an official exchange rate. To keep this local exchange rate tied to the pegged currency, the bank will buy and sell its own currency on the foreign exchange market to balance supply and demand.