Fixed Exchange Rate

Published Apr 29, 2024

Definition of Fixed Exchange Rate

A fixed exchange rate, also known as a pegged exchange rate, is a type of exchange rate regime in which a currency’s value is fixed or pegged by a monetary authority against the value of another currency, a basket of other currencies, or another measure of value, such as gold. The primary objective of a fixed exchange rate system is to maintain a currency’s value within a very narrow margin. Central banks or monetary authorities achieve this by directly intervening in the foreign exchange market, buying and selling their own currency against the currency to which they are pegged.

Example

To illustrate, consider Country A, which has decided to peg its currency to the US dollar at a rate of 1 to 10. This means that 1 US dollar can be exchanged for 10 of Country A’s currency and vice versa. To maintain this fixed exchange rate, Country A’s central bank must continually monitor the forex market and be ready to intervene if the value deviates from this fixed rate. For instance, if there is a high demand for Country A’s currency, its value would naturally rise. To prevent this, the central bank will increase the supply of its currency in the market by selling its reserves of its own currency and buying US dollars, thereby maintaining the pegged rate.

Why Fixed Exchange Rate Matters

Fixed exchange rates can provide a high level of predictability for international trade and investment because they eliminate the risks of exchange rate fluctuations. This stability encourages economic transactions with other countries by reducing uncertainty and making it easier for businesses and governments to plan ahead. However, maintaining a fixed exchange rate requires a country to have large reserves of foreign currencies to defend its pegged rate, which can limit monetary policy flexibility. For instance, to defend a fixed exchange rate, a country might need to raise interest rates to combat inflation, which can lead to slower economic growth.

Moreover, a fixed exchange rate regime can impose significant constraints on a country’s monetary policy. The need to maintain the exchange rate peg can prevent the central bank from adjusting interest rates as needed for domestic economic stability. This can lead to situations where monetary policy must prioritize exchange rate targets over other economic objectives, such as controlling inflation or unemployment.

Frequently Asked Questions (FAQ)

What are the main advantages and disadvantages of a fixed exchange rate?

Advantages of a fixed exchange rate include stabilizing the economy by controlling inflation, reducing uncertainty in international trade, and encouraging foreign investment due to predictable exchange rate movements. However, disadvantages include the need for large currency reserves to defend the peg, reduced flexibility in monetary policy, and the potential for economic misalignments if the fixed rate does not reflect the currency’s true value on the global market.

How do countries maintain a fixed exchange rate?

Countries maintain fixed exchange rates by buying and selling their own currency on the foreign exchange market to counterbalance any pressures that would move the currency away from its pegged rate. This usually involves the use of foreign exchange reserves. Alternatively, a country can use monetary policy tools, such as changing interest rates or imposing capital controls, to influence the demand for its currency.

What could lead a country to abandon its fixed exchange rate?

A country might abandon its fixed exchange rate if maintaining it becomes unsustainable – for example, if its currency reserves are depleted by defending the peg or if the fixed rate leads to severe economic imbalances, such as persistent inflation or deflation, economic recessions, or speculative attacks on the currency. Additionally, significant changes in the global economy, like the rise or fall of major trading partners, can make the fixed rate untenable.

Fixed exchange rate systems aim to provide economic stability and predictability but come with challenges requiring careful management and significant reserves to be sustainable. The balance between maintaining such a regime and allowing currency values to float freely is a complex task that central banks and monetary authorities must navigate thoughtfully.