Fixed or floating exchange rates?

[Karpatsky]

What a fixed rate functionally means is that the central bank is selling or buying the home currency in theoretically infinite amounts at the given rate, keeping the market at that price. This makes things easier for international capital flows and so makes the country a safer bet for import, export, and investment for the country which is being pegged to.

There are two major downsides: first, the country's ability to maintain the peg is dependent on its forex reserves (or, in the olden days, gold reserves). This means a crisis either in the country or the country being pegged to could require the government to spend down its reserves very very quickly to maintain the peg. You can see how even the whisper of it failing to be able to do so could become a self-fulfilling prophecy. The only way to prevent this would be to temporarily suspend convertibility (and so free flow of capital), which of course kills investors' and importers' interest in doing business with your country.

Second, a peg functionally removes the country's monetary policy autonomy. If the CB is using its ability to inflate or deflate to maintain the peg, it can't use it to fight inflation or stimulate growth. This was once called the 'golden straightjacket', and is one of the key reasons for the long duration of the Eurozone crisis - Germany and other countries which were doing relatively well were unwilling to inflate the Euro, forcing countries like Greece onto austerity which slowed their recovery.

These three potential desirable policies (fixed exchange rates, monetary policy autonomy, free capital flows) are sometimes called the 'impossible trinity'. You can have two, but it's impossible to have three in the long run.