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A pegged exchange rate occurs when one country fixes its currency’s value to the value of another country’s currency. It makes the exchange rate between the two countries constant and stable. But pegging an exchange rate has both pros and cons.

The biggest advantages come from the effect it has on a country’s exports and trade, especially between a nation with low production costs and another country with a stronger currency. A richer, more mature nation may choose to produce its goods in a less mature nation, where production costs are smaller. When those less mature nations translate their earnings into their domestic currencies, they make a larger profit, creating a win/win situation for both countries.

A pegged exchange rate also supports a rising standard of living and economic growth. And it protects a nation from volatile swings in the foreign exchange rate, which reduces the likelihood of a currency crisis.

Among the disadvantages is the large amount of reserves a central bank has to maintain to make a pegged exchange rate work. Those large reserves can spark higher inflation, which causes prices to rise, creating problems for a country’s economic stability. The central bank must also buy or sell its currency on the open market to keep its value in line with the pegged nation’s currency.

Despite the negatives, many major and minor economies favor a pegged exchange rate. A country can gain trading advantages while protecting its economic interests, but these advantages come at a price.

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