A number of economies fix the value of their currency against a larger one instead of letting it float. The choice trades one kind of control for another.
A peg imports monetary credibility
A central bank with a history of high inflation struggles to be believed when it promises restraint, and expectations of inflation help produce inflation.
Fixing the exchange rate to a currency managed by a credible institution borrows that institution's reputation, because maintaining the peg constrains what the domestic authority can do.
The commitment is visible and easily checked, which is precisely why it can be persuasive where a stated inflation target is not.
Trade-dependent economies value price stability more
An economy whose exports are concentrated in one commodity or whose imports dominate domestic consumption is exposed to exchange rate swings in a direct way.
A stable rate against the currency in which those goods are invoiced removes a large source of uncertainty for producers, importers and the government's own budget.
Small open economies therefore peg far more often than large diversified ones, which can absorb currency movement internally.
The cost is the interest rate
Capital moves towards higher returns, so a country cannot simultaneously fix its exchange rate, allow money to cross its borders freely and set its own interest rate.
Pegging while remaining open means following the anchor country's policy, including when that policy is tightening into a domestic slowdown.
The alternative is capital controls, which preserve monetary independence by restricting the movement that would otherwise break the peg.
Defending a peg consumes reserves
To hold the rate when the currency is under pressure, the central bank sells foreign reserves and buys its own currency, which is finite by definition.
Markets watch the reserve position closely, and a visibly shrinking buffer invites more pressure rather than less, because a break becomes more likely.
Raising interest rates sharply is the other defence, and it works by making the currency attractive to hold at the cost of domestic borrowers.
Exits are rarely orderly
Because the peg is a public promise, abandoning it is read as a failure, so governments tend to defend it past the point where defence is affordable.
The eventual adjustment is then large and sudden, hitting borrowers who took foreign-currency debt on the assumption that the rate would hold.
Softer arrangements exist for this reason, including bands and managed floats that allow gradual movement without a single defended line.