Often times astute observers of international news, a category you likely include yourself in, will hear that some politician or government minister has commented on such and such country trying to “peg” or fix their exchange rate to a certain value versus another country’s currency. You may be asking yourself what the big deal is if Mexican Pesos are fixed at ten per two British Pounds, let’s say. I’m glad you asked!
If Mexico’s central banking authority (these countries were chosen purely for the sake of argument) decides that they don’t want to allow the value of their currency to rise and fall with market conditions on the world exchange rate market, they may take steps to ensure that the value of their currency is artificially stabilized versus some other country’s. In so fixing the value of the Peso to the Pound, what has in effect happened is that goods produced in Mexico will be less expensive than goods produced in England.
In pegging or fixing the exchange rate between the Peso and the Pound, what the Mexican central bank has in effect tried to do is stabilize trade relations between their countries and also stabilize the value of their currency. In so doing, however the Pound rises and falls, the Peso will do so in at the same rate. This is most often done in smaller nations whose markets are tied to larger ones.
The biggest problem with this arrangement, from the British view, would be that goods from Mexico would permanently become less expensive than goods produced at home in real terms. As such, items that are manufactured in the United Kingdom would be, all other things being equal, consumed at a lower rate than those produced in Mexico by the British markets. This can lead to a trade imbalance, which can have consequences for both countries.