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A government or central bank using a fixed exchange rate has linked the value of its currency to the value of another country’s currency, or the price of gold.

Exchange rates are the rates at which one currency can be exchanged for another. For example, if the United States dollar has an exchange rate of 1:2 to the Canadian dollar, one U.S. dollar will buy two Canadian dollars.

With a fixed exchange rate, a country determines that the value of a single unit of its currency is worth a certain amount of another country’s currency.

For instance, a small country fixes its currency to the U.S. dollar, saying one unit of its money is worth $2. To maintain the rate, the country’s central bank will buy or sell its own currency on the foreign exchange market in return for U.S. dollars.

This will keep the exchange rate steady. But it requires the small country to maintain a large amount of U.S. dollars in reserve so that it can release or absorb extra dollars when necessary.

Fixed exchange rates enable a currency’s value to remain relatively stable, and can help lower inflation, which encourages investment.

But a fixed exchange rate can also cause problems. A smaller country that fixes its currency to a larger country’s currency loses its monetary independence, and in some instances, its control.

A fixed exchange rate is also known as a pegged exchange rate.

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