Fixed exchange rate

Also called: Pegged exchange rate, Currency peg, Hard peg · Topic: Balance of Payments and Exchange Rates · NCERT: Class 12, Ch 6 "Open Economy Macroeconomics"

Meaning

A fixed exchange rate (also called a pegged rate or currency peg) is a system where the government announces the price of its currency in terms of another currency, and the central bank buys or sells foreign exchange at that price so the market rate cannot move away from it.

It matters because it shows the basic trade-off in exchange-rate policy. A fixed rate gives traders certainty. The price is that the central bank must keep enough forex reserves to defend the rate. If people stop believing it can do that, the peg can collapse. This happened to India in 1991.

Explanation

How a peg is defended

• Exchange rate: the price of one currency in terms of another. In India it is written as ₹ per $.
• ₹/$ rises (₹50 → ₹70) means the rupee is weaker.

• ₹/$ falls (₹70 → ₹50) means the rupee is stronger.

• Forex reserves: foreign currency, gold and similar assets that the RBI holds. They are the "ammunition" the RBI uses to defend the rate.

• Official reserve transactions: the RBI's purchases and sales of forex. They are recorded in the Balance of Payments (BoP) and make it balance. Under a fixed rate they are never zero.

Case A: rate fixed ABOVE the market rate (weak rupee), NCERT Class 12, Fig. 6.3

• The market rate, where demand for $ equals supply of $, is ₹50/$. The government fixes it at e₁ = ₹70/$.
• At ₹70:
• exporters get more rupees for each dollar, so exports rise and the supply of $ rises;

• imports cost more, so the demand for $ falls.

• Supply of $ > demand for $. This gap is AB in Fig. 6.3.

• The RBI buys the extra dollars so the rate does not fall back to ₹50. As a result, reserves pile up.
• Purpose: a cheap rupee that promotes exports.

Worked example (Case A)

• At ₹70/$: supply of $ = $120 bn and demand for $ = $90 bn.
• The RBI must buy $120 bn − $90 bn = $30 bn (the gap AB).
• It pays ₹70 × 30 bn = ₹2,100 bn (₹2.1 lakh crore) in newly created rupees.
• Side effect:
• more rupees are now in circulation;
• so domestic money supply rises;
• this can push up prices.

Case B: rate fixed BELOW the market rate (strong rupee), e₂

• The rupee is kept artificially strong:
• imports become cheap;

• so demand for $ is greater than supply.

• The RBI sells dollars from its reserves to fill the gap.

• Reserves are limited. When they run out:
• people who cannot get dollars at the official rate pay more for them illegally;
• a black market for foreign exchange grows (an illegal market where the dollar sells above the official rate).

Changing the peg: devaluation and revaluation

• Under a fixed rate, only the government can change the rate.
• Devaluation: the government raises ₹/$ (e.g. ₹50 → ₹60). The rupee becomes cheaper.

• Revaluation: the government lowers ₹/$. The rupee becomes dearer.

• Worked example (% devaluation): ₹50 → ₹60 per $.

• Change in the ₹/$ rate = (60 − 50)/50 × 100 = 20%.
• The rupee's value in dollars falls from 1/50 = $0.020 to 1/60 = $0.0167. That is a fall of about 16.7%.
• Exam trap: the two percentages are different. Check which one the question asks for.

Types of peg: from hardest to softest

Regime	Meaning	Example
Dollarisation	No national currency. A foreign currency (usually the US $) is used	Ecuador, Panama
Currency board	Domestic currency is issued only against 100% foreign-reserve backing at a fixed rate	Hong Kong since 1983, ~HK$7.8/$
Conventional peg	Fixed to one currency or a basket, with small bands. Can be adjusted	Gulf states' pegs to the $
Crawling peg	Peg is adjusted from time to time in small steps, often in line with inflation differences	—

• Hard peg usually means the first two rows. In these, giving up the peg is very difficult by design.
• Crawling peg, worked example:
• the peg is ₹80/$;
• Indian inflation is 5% and US inflation is 2%, a gap of 3%;
• so the peg moves about 3% a year, roughly ₹80 → ₹82.4, often in monthly steps of about 0.25%.

History of fixed systems (NCERT Class 12)

• Gold standard: each currency had a fixed value in gold, so the rates between currencies were fixed.
• Bretton Woods system (1944 to early 1970s): a fixed but adjustable system.
• The US dollar was tied to gold at $35 per ounce.
• Other currencies were tied to the dollar.
• A country could change its peg only if it had a "fundamental" imbalance.

• It collapsed when the US stopped converting dollars into gold (1971), after repeated speculative attacks.

• After that, the world moved to managed floating without any formal agreement.

Why pegs break: credibility and speculative attacks

• A fixed rate works only if people believe the central bank has enough reserves to defend it.
• Speculative attack (a rush to sell a currency because people expect it to be devalued). It happens step by step:
• reserves look too small, so speculators expect a devaluation;
• they sell the domestic currency and buy forex;
• the central bank loses even more reserves defending the peg;

• finally it is forced to devalue or let the currency float. The fear makes itself come true.

• Examples:

• Black Wednesday (16 Sept 1992): the UK pound was forced out of the ERM (European Exchange Rate Mechanism, a system that kept European currencies within set bands).

• Thai baht (2 July 1997): Thailand gave up its peg and floated the baht. This set off the Asian financial crisis.

• Impossible trinity (Mundell-Fleming "trilemma"): a country cannot have all three of these at once: 1. a fixed exchange rate; 2. free capital movement (money flows freely in and out); 3. an independent monetary policy (setting its own interest rates).

• Why a peg with free capital loses monetary independence:

• the central bank cuts interest rates;
• investors move money abroad to earn higher returns;
• demand for $ rises and the peg comes under pressure;

• the central bank must sell reserves or raise rates again.

• So a peg with free capital (e.g. Hong Kong's currency board) gives up independent monetary policy. A peg with independent policy (Bretton Woods era, pre-1991 India) needs capital controls (limits on money moving in and out).

In India

• Before 1991: India had a near-fixed, government-managed rate with capital controls. This fits the "fixed rate + independent policy" choice of the trilemma.
• 1991 BoP crisis: forex reserves fell so low that they could pay for only about two weeks of imports. The peg lost credibility.
• The step-by-step exit from the peg:
• July 1991: the rupee was devalued in two stages (1 and 3 July 1991), about 18% in total in USD terms [3].
• March 1992: LERMS (Liberalised Exchange Rate Management System), a dual exchange rate. Part of forex earnings was converted at the official rate and the rest at the market rate [2][3].
• 1 March 1993: a unified, market-determined exchange rate replaced LERMS [2][3].
• August 1994: the rupee became convertible on the current account (for trade and similar payments), and India accepted Article VIII of the IMF's Articles of Agreement [3].

• 1999: FEMA replaced FERA, 1973. The old law punished forex violations as crimes. The new one "manages" forex [3].

• Today: India does not have a fixed rate.

• The RBI intervenes only to curb excess volatility, without targeting any fixed level of the rupee [5].

• The IMF 2025 Article IV report calls India de jure floating (what India officially says) but de facto crawl-like (what the IMF sees in the data) [5].

• The buffer: forex reserves were US$ 698.19 bn (week ended 25 July 2025) [4], compared with two weeks of import cover in 1991.

Don't confuse with

• Floating exchange rate: the market alone sets the rate and official reserve transactions = 0. Under a fixed rate the central bank must keep buying or selling forex.
• Managed float ("dirty floating"): the market mainly sets the rate and the central bank only smooths sharp swings. It does not defend a fixed level. This is India's official regime.
• Devaluation vs depreciation: devaluation is a government decision under a fixed regime. Depreciation is a market outcome under a flexible regime.
• Crawling peg vs conventional peg: a crawling peg is moved often in small, planned steps (often linked to inflation gaps). A conventional peg stays at one level until the government changes it.

Prelims Hooks

• Rate fixed above the market rate (weak rupee): the RBI buys $ and reserves rise. Rate fixed below it: the RBI sells $, reserves fall, and a black market in forex can appear.
• Bretton Woods (1944 to early 1970s): a "fixed but adjustable" system with the dollar tied to gold at $35 per ounce. It ended when the US stopped converting dollars into gold in 1971.
• Currency board: domestic currency issued only against 100% reserve backing. Hong Kong has had one since 1983 (~HK$7.8/$).
• July 1991: devaluation in two stages, ~18% in total in USD terms [3]. LERMS (dual rate) came in March 1992, a unified market rate on 1 March 1993, and current-account convertibility / IMF Article VIII in August 1994 [2][3].
• Impossible trinity: out of a fixed rate, free capital flows and independent monetary policy, only two are possible at once.
• Trap: ₹50 → ₹60 is a 20% rise in ₹/$ but only a ~16.7% fall in the rupee's dollar value.

Mains Points

• Credibility is the real anchor of a peg:
• a fixed rate with low reserves and a rising current account deficit (more money going out for imports and payments than coming in) invites a speculative attack (India 1991, UK 1992, Thailand 1997);

• India's reform path (devaluation → LERMS → unified rate → current-account convertibility) shows how to move away from a peg in steps, not overnight [3].

• Trilemma trade-off for India:

• a hard peg with an open capital account would take away the RBI's control over interest rates;
• full capital-account convertibility risks sudden outflows (the 1997 Asian crisis is the warning);

• so India follows a middle path: partial capital-account openness + managed float + large reserves (US$ 698.19 bn, July 2025 [4]).

• Stability vs flexibility:

• a peg gives exporters and importers certainty;
• but it fixes BoP imbalances by using up reserves, not by letting the price adjust;
• a rate kept too weak also adds to money supply and inflation (see the ₹2.1 lakh crore example above);
• the IMF's "crawl-like" label for India [5] shows the debate is still alive: heavy intervention moves a managed float closer to a soft peg.

Related concepts

• Devaluation
• Revaluation
• Black market for foreign exchange
• Speculative attack
• Managed floating
• Forex intervention
• Crawling peg
• Currency board
• Impossible trinity
• Competitive devaluation

Read more

• Exchange-rate regimes: fixed, floating and managed float