Fixed exchange rate is also known as pegged exchange rate system. Under this system, the exchange rate will be determined by central bank. The intervention made in the foreign exchange market by the central bank to keep exchange rate fixed is known as pegging. This can be explained with the help of diagram. Which is given below.
Here e* is the market determined exchange rate. Suppose that government fixes exchange rate as e1 At e, exchange rate the demand for foreign exchange is greater than the supply of foreign exchange. If there is no. control over exchange rate. It will increase to e*. In order to maintain the exchange rate at e1 the central bank will sell AB amount of foreign exchange in the market. So the exchange will be maintained at e*.
Suppose that the central bank fixes the exchange rate e2. If there is no central bank intervention in the market the exchange rate will fall to e*. In order to maintain the exchange rate at e2 the central bank will purchase CD amount of foreign exchange from the market. Thus fixed exchange rate is maintained.
