The maintenance of a fixed exchange rate, or a nearly fixed exchange rate, between one currency and another is a practice commonly employed to stabilize economies or facilitate trade. It involves a central bank actively intervening in the foreign exchange market to maintain the predetermined value of its currency relative to another, often a more stable or widely used, currency. For example, Country A’s monetary authority might commit to maintaining its currency at a rate of 5 units of its currency per 1 unit of Currency B. To achieve this, the central bank buys or sells its own currency in the foreign exchange market as needed, using its foreign exchange reserves.
This strategy offers several potential advantages, including reduced exchange rate volatility, which can promote international trade and investment. It can also serve as a tool for controlling inflation, particularly if the reference currency is known for its stability. Historically, such arrangements were a cornerstone of the Bretton Woods system, which aimed to foster post-World War II economic stability. However, maintaining such a system requires a substantial level of foreign exchange reserves and can limit a country’s monetary policy autonomy. The commitment to a specific rate can also become vulnerable to speculative attacks if the market believes the rate is unsustainable.
