So far we have treated the case of floating exchange rates with currency prices determined in open world markets. This is by far the most common scenario in the world today and indeed throughout history

Still, in other cases the world has seen fixed, or pegged, exchange rates, where currencies do not fluctuate against one another on a daily basis. Fixed exchange rate systems can take three forms:

Panama, Ecuador, and El Salvador all use U.S. dollars as their currency; this is called dollarization. The central banks of these nations have no active role in managing their money supplies.

The disadvantage of this approach is that Ecuador must buy and save enough dollars to use that currency. The advantage is that, once in place, Ecuador receives the monetary policy of the United States. Once the transition is made, the common currency runs on automatic pilot. Overall, it is plausible that the U.S. Fed does a better job than would an Ecuadorian central bank. Indeed, at the time of dollarization in 2000, the rate of inflation in Ecuador was above 50%. Today, the rate of inflation in Ecuador roughly tracks that of the United States and of course this is much lower.

Many European countries gave up their currencies and created the euro, a common currency under the supervision of the European Union and (as of early 2014) shared by 17 different EU countries. The wealthier European countries, such as Germany and France, saw the euro as a way to unify Europe economically. Some of the poorer countries, such as Greece, saw the euro as a way to obtain a more stable currency. In any case, all of these countries allow the European Central Bank to control their common monetary policy; the euro does not belong to any single country. The euro, however, is unique and no other comparable arrangement exists today. The euro, however, started to come under considerable strain in the early part of 2010. The basic dilemma is simple: some countries in the eurozone, such as Greece, want a relatively expansionary monetary policy. Since the Greek economy was shrinking during 2010, they wanted monetary policy to stimulate aggregate demand. Other countries in the eurozone, such as Germany, were growing rapidly and did not want an expansionary monetary policy. So far Germany is getting its way, but it remains to be seen whether it makes sense for Greece or other slower growing countries to remain in the eurozone forever.

A country could promise to convert its currency into U.S. dollars, or some other currency, at a specified rate. Holding sufficient reserves of the foreign currency to ensure conversion would make this promise more credible. Since 1983, Hong Kong has pledged that 7.80 Hong Kong dollars are equal to 1 U.S. dollar and required Hong Kong banks to have full American backing for any note issued. For many years, Austria pegged its currency to the value of the German mark, prior to adopting the euro.

Option 3 is, of course, a matter of degree. Economists refer to a “peg” to describe a relatively rigid commitment to a specified conversion rate. A dirty, or managed, float refers to a relatively loose commitment to a floating exchange rate. Under a dirty float, a currency will vary in value daily, although the central bank or treasury will intervene if that currency moves too far outside a band of intended or preannounced values.

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The pegging option has become less popular over time. Many nations have attempted currency pegs, but usually they have failed. For instance, Thailand, Indonesia, Brazil, and Argentina, among others, all tried to peg their currencies to the U.S. dollar or to a weighted basket of currencies. In each case, the peg was broken by speculators, largely because these countries did not and could not match the monetary and fiscal policies of the United States. Why hold one Argentine peso—supposedly equal in value to a dollar throughout the late 1990s—when you can hold a U.S. dollar instead?

When Argentina pegged its currency to the U.S. dollar in 1991, it promised that 1 Argentine peso was equal in value to 1 U.S. dollar. For a while, markets believed this promise. The Argentine economy was doing well, foreign investment was flowing in, and the Argentine government instituted many desirable economic reforms.

But over time people began to doubt whether this peg could be maintained. Eventually, the weaknesses of the Argentine economy became revealed more clearly. The government was unable to bring about true fiscal balance. Many foreign investors began to believe that the Argentine peg would break and that the one-to-one rate would go away. This would mean that 1 peso would be worth less than 1 U.S. dollar. Many people who had invested in pesos withdrew their money from the country or tried to convert their peso holdings into dollars before the one-to-one rate disappeared. Argentine citizens panicked as well, and many of them also sought to convert their pesos into U.S. dollars.

The resulting rush to convert pesos into dollars put great strain on the peso. The Argentine government did not have enough U.S. dollars to keep up the value of the peg. The result was that the peso fell from being worth a dollar (January 6, 2002) to being worth about 26 cents (June 28, 2002), across the course of only five and a half months. In other words, the Argentine government had to officially announce a new peg with a much lower value for the Argentine currency.

The rapid reduction in the official exchange rate ruined the economic reputation of the country and the withdrawal of money from the country led to a collapse of the banking system. This is sometimes called capital flight. Argentina probably would have been better off had it never pegged its currency in the first place.

Overall, the lesson is simple. Most countries should not attempt exchange rate pegs. An effective peg requires a very serious commitment to a high level of monetary and fiscal stability. If a country doesn’t have as sound an economy as that of the United States, in the long run it cannot peg to the U.S. dollar.