One of the key problems with a country adopting a fixed exchange rate is identified clearly by thee concept of the Impossible trinity.
The Impossible Trinity is a concept that states that a country can have only a maximum possible of two out of three macroeconomic measures : a fixed exchange rate, an independent monetary policy and free capital movement across borders. Let us see how this works.
Assume a country that practices an independent monetary policy but maintains fixed exchange rates. This means that the country can practice open market operations as well as keep its currency’s exchange rate fixed. The value of an economy rises or falls depending on the capital investment and trade happening in it. The above conditions can be maintained only if the country maintains the exact amount of trade and investment that it currently has. Thus, free capital movement cannot be possible.
Now assume a country with a fixed exchange rate and free capital movement. Free capital movement would mean that the value of domestic country’s products can rise or fall with respect to another country. As the currency is fixed, the central bank will have to buy or sell foreign exchange in order to maintain the exchange rate. This would mean a loss of freedom in monetary policy setting and the central bank will have to play a responder to capital flow dynamics.
Now consider the final case of an economy with free capital flow and an independent monetary policy. The only way a central bank can conduct open market operations and allow free capital flows is by allowing the value of its currency to move dynamically. Hence, a fixed exchange rate cannot be implemented.
The Impossible trinity is important because governments frequently try to control two aspects of this triad without considering the effects it has on the third aspect. The rule is a caveat for market operators and governments that control and free markets cannot happen at the same time.