Fixed exchange rate is also called pegged exchange rate. This is a type of exchange rate where the value of currency is matched with the value of either another currency or with the basket of other currencies or with gold. As the reference value of the currency rises or falls, the value of the currency pegged to it also changes. The currency that is used for a fixed exchange rate is known as the fixed currency while floating exchange rate is the opposite of the fixed exchange rate.
In another way it can also be said that the fixed exchange rate is the exchange rate regime of a country in accordance to which the central bank of the country fixes the official exchange rate of its currency with respect to another country’s currency.
The major purpose behind adopting the fixed exchange rate system is to maintain the value of currency of a country within a fixed and narrow bracket. The main utility of fixed exchange rate system is that it gives greater certainty to the exporters and importers of a country. In order to maintain a low inflation rate the governments use fixed exchange rate system.
Many economists believe that floating exchange rates are more useful in most of the circumstances than the fixed exchange rates. The reason behind this belief is that the floating rates are more responsive to foreign exchange market volatility. It is also hugely believed that under the fixed exchange rates policy, the governments cannot use an independent monetary policy in order to achieve internal economic stability. But the use of fixed exchange rates may be very useful in certain situations because of its greater stability.
Some economists also argue that the fixed exchange rate system masks the valuable information that is needed for the proper functioning of a financial market. This happens because under the fixed exchange rate regime, the currencies do not represent their true market value.
The government buys or sells its own currency in the open market in order to maintain a fixed exchange rate. To do this the governments need to maintain reserves of foreign currencies. When the exchange rate of the currency drifts largely below the desired rate, the government starts buying its own currency off the market using its foreign currency reserves. This action creates greater demand of currency in the market thus the price of currency is pushed up. On the contrary, if the exchange rate of the currency drifts largely above the desired rate, government takes opposite measures.