Two answers to one question: who sets the price?
The previous guide showed how an exchange rate is just a price — the price of one currency in terms of another — and how, left alone, it is pushed around by the same supply and demand you met at the very start of this ladder. Exporters earning foreign cash, tourists buying yen, investors chasing higher interest: every one of them is a buyer or seller in the foreign exchange market, and their tug-of-war moves the price minute by minute. The deep question this guide answers is simple to ask and hard to live with: should a government just *let* that happen, or step in and *pin the price down*?
Answer one is a floating rate. The government stands back and lets the market clear the price on its own, exactly as the price of coffee or steel is set by who wants it and who is selling. The rate wanders all day, sometimes a lot, and nobody promises it will be the same tomorrow. The US dollar, the euro, the yen, the pound — the world's biggest currencies all float. Answer two is a [[fixed-exchange-rate|fixed exchange rate]]: the government picks a target — say, exactly 7 of its units to one US dollar — and publicly commits to keep the price there, defending that number with its own buying and selling. A fixed rate held against a chosen anchor currency is usually called a [[currency-peg|currency peg]].
How you actually hold a price still
A peg is not a law of nature; it is a price control, and like the price ceilings you studied earlier, a target price only holds if someone absorbs the surplus or shortage. Imagine the central bank promises 7 units per dollar, but the market on its own would settle at 8 (the home currency is naturally weaker than the promise). At the official 7, the home currency is being held *too strong* — too few people want it at that price, so there is excess supply of it and excess demand for dollars. To stop the price from sliding to 8, the central bank must itself buy up the unwanted home currency, paying for it out of its hoard of dollars: its [[foreign-exchange-reserves|foreign exchange reserves]].
This reveals the cruel asymmetry at the heart of every peg. Defending a currency that the market wants *stronger* is easy and can go on forever: the central bank just prints its own currency and sells it, buying foreign cash — it can never run out of its own currency, so its reserves only grow. But defending a currency the market wants *weaker* is the dangerous direction: the bank must spend its finite reserves to buy back its own currency, and reserves are a bucket with a bottom. When the bucket runs dry, the defence collapses. This is why pegs almost never break upward and so often shatter downward.
Peg promised: 7 home units = 1 USD Market alone would settle at: 8 home units = 1 USD -> at the peg, home currency is held TOO STRONG -> excess supply of home units, excess demand for USD To hold the line, the central bank must BUY home units, paying with its USD reserves: Reserves start: $100 billion Each month it sells $5bn of reserves to defend the 7 After 20 months: reserves = $0 -> peg breaks Market wants home currency STRONGER instead? Bank prints home units, buys USD -> reserves only GROW (it can never run out of its own currency) The two directions are NOT symmetric.
Devaluation and revaluation: moving the goalposts
Sometimes a government keeps the peg but officially changes the number it is pegged to. Cutting the official value of the home currency — say, moving the peg from 7-per-dollar to 8-per-dollar so each home unit now buys fewer dollars — is a devaluation. Raising it the other way, to a stronger 6-per-dollar, is a revaluation. These twin moves are [[devaluation-and-revaluation|devaluation and revaluation]], and the key word is *official*: they are deliberate decisions to reset the target. Note the vocabulary trap from the last guide — when a *floating* currency loses value it is called depreciation, not devaluation. Devaluation is the word reserved for a government deliberately moving a peg.
Why would a country devalue on purpose? Because a weaker currency makes its exports cheaper to foreigners and imports dearer at home — a way to try to swing the trade balance toward more selling and less buying, and to boost domestic jobs. Suppose a shirt costs 80 home units to make. At 8-per-dollar that shirt costs a US buyer $10; devalue to 10-per-dollar and the very same shirt now costs the American only $8, with no change in the factory at all. The catch is just as concrete: every import — oil, machines, medicine — instantly gets more expensive in home-currency terms, which feeds straight into inflation and squeezes every household's grocery bill. A devaluation is not free money; it is a transfer from consumers and importers to exporters.
The bargain each regime strikes
Now we can weigh the two honestly, because each genuinely buys something real and surrenders something real — there is no free choice here, only a trade-off, exactly the way every choice on this ladder has been. A fixed rate buys certainty. A peg removes exchange-rate risk for importers, exporters, and foreign investors: a factory can sign a year-long contract knowing exactly what it will be paid in its own money. For a small country whose trade and debts are dominated by one big partner, that stability is enormously valuable, and pinning to a low-inflation anchor like the dollar can even *import* the anchor country's credibility and tame runaway prices at home.
But the peg surrenders something just as precious: control of your own monetary policy. To hold the rate, your interest rates must shadow the anchor country's, whether or not that suits your own economy. If your country slides into recession and needs cheap money, but the anchor country is fighting inflation with high rates, you are stuck: cut your rates and money flees abroad chasing the higher return, the currency weakens, and your reserves bleed defending the peg. A floating rate makes the opposite bargain — it gives that monetary freedom back, and it acts as a shock absorber: when bad news hits, the currency can simply slide and cushion the blow, rather than forcing the whole economy to grind down to defend a number. The price of that freedom is the day-to-day uncertainty and the swings that businesses must hedge against.
When the anchor becomes the trap
Here is the deepest and most honest point of the whole guide: the very thing that makes a peg stabilizing in calm times is what makes it dangerous in a storm. A credible peg invites everyone to *stop worrying* about the exchange rate — so banks, firms, and governments cheerfully borrow in foreign dollars, confident the rate will never move against them. That borrowing is safe only as long as the peg holds. The trouble is that a fixed rate, like any price control, can drift away from the price the economy actually warrants: if home inflation runs hotter than the anchor's for years, the pegged rate quietly becomes *overvalued*, exports lose their edge, and a gap opens between the official price and the real one.
Speculators are not stupid — they see that gap, and they see the reserve bucket emptying. They start betting against the currency, selling it hard, which forces the central bank to spend reserves even faster to hold the line. This becomes a brutal one-way bet: if the peg holds, the speculators lose only a little, but if it breaks, they win big as the currency collapses. The defence can become self-defeating, because the high interest rates needed to defend the peg can crush the very economy that was supposed to justify it. Asia in 1997 and Argentina in 2001 are the textbook wreckages — pegs that were anchors for years and then, in months, turned into traps that magnified the crash they were meant to prevent.
So neither regime is simply "better" — and economists genuinely argue over which suits which country, with no settled winner. A floater accepts noisy day-to-day prices in exchange for autonomy and a built-in shock absorber. A pegger buys stability and borrowed credibility, but mortgages its monetary independence and lives with the standing risk that the anchor becomes a trap. Lurking underneath both is a constraint so fundamental it deserves its own guide: you cannot have a fixed rate, free movement of money across the border, and an independent monetary policy all at once. That iron limit — the [[impossible-trinity|impossible trinity]] — is where this rung goes next, and it explains *why* every choice in this guide came packaged with a sacrifice.