Fixed exchange rate

Fixed exchange rate is a type of currency regime in which a currency’s value is tied to the value of another currency, or to a basket of currencies. The exchange rate between two currencies is predetermined and maintained by a central bank or monetary authority. This means that the value of a currency is determined by the government and does not fluctuate with market forces of supply and demand. National governments typically use fixed exchange rates to maintain macroeconomic stability and reduce financial volatility.

Example of fixed exchange rate

• The United States Dollar and the Euro are subject to a fixed exchange rate set by the European Central Bank and the US Federal Reserve. The exchange rate is determined by a central bank and is designed to keep the value of the two currencies stable, regardless of market forces. This type of currency regime has been in place since the introduction of the Euro in 1999.
• The Chinese Yuan is subject to a managed float system, where the exchange rate between the Yuan and other currencies is set by the Chinese government. The Chinese government will intervene in the foreign exchange markets to keep the Yuan’s exchange rate within a certain range. This type of currency regime has been in place since the early 2000s.
• The Hong Kong Dollar is pegged to the US Dollar under a currency board system. Under this system, the Hong Kong Monetary Authority (HKMA) has to maintain a certain amount of US dollars in its reserves for every Hong Kong Dollar issued. This type of system has been in place since 1983.

When to use fixed exchange rate

A fixed exchange rate is useful in certain situations, such as when a country wants to maintain the value of its currency, or when a government wants to control inflation or maintain a certain level of economic stability. It is also used to protect a country’s currency from external economic shocks. Some of the specific applications of a fixed exchange rate include:

• To maintain the value of a currency, as a way of promoting stability and reducing inflation. This is particularly important for countries with weaker economies, as a strong currency can attract foreign investment and help boost economic growth.
• To protect a country’s currency from external economic shocks. For example, if a country is heavily reliant on exporting goods and services, it may choose to peg its currency to a stronger currency to protect it from currency fluctuations.
• To control the amount of money in circulation. By pegging a currency to another, a government can control the amount of money in circulation, as well as the exchange rate between two currencies.
• To promote international trade. By using a fixed exchange rate, countries can avoid the need to adjust their exchange rates when trading with one another. This can make it easier to conduct international trade, as traders do not have to worry about fluctuating exchange rates.

Types of fixed exchange rate

Fixed exchange rate is a type of currency regime in which a currency’s value is tied to the value of another currency, or to a basket of currencies. There are three main types of fixed exchange rate regimes:

• Pegged Exchange Rate: A pegged exchange rate is when a currency’s value is directly linked to the value of another currency. The central bank of a country sets a rate at which its currency will be exchanged with a foreign currency, usually the US dollar. The rate is usually adjusted occasionally to keep the value of the currency in line with changes in the other currency.
• Currency Board System: A currency board system is a type of fixed exchange rate regime in which a currency’s value is determined by a basket of other currencies. The central bank of a country sets the exchange rate of its currency to a fixed exchange rate determined by the currencies in the basket. The currency board system is used to promote stability and reduce volatility in the currency market.
• Dollarization: Dollarization is a type of fixed exchange rate regime in which a country adopts a foreign currency as its own. Dollarization is typically an extreme measure taken when a country’s currency is too volatile or unstable to maintain a fixed exchange rate. By adopting the US dollar or another foreign currency, a country can stabilize its currency and reduce its exposure to financial market volatility.

Advantages of fixed exchange rate

Fixed exchange rates provide governments with many advantages. These include:

• Increased macroeconomic stability and reduced financial volatility, as the value of the currency remains constant and is not subject to market forces of supply and demand.
• The ability to control the money supply and inflation, as the central bank or monetary authority can set the exchange rate and use it as a tool to influence the economy.
• Improved trade and investment flows, as businesses have a greater certainty when trading, investing and conducting transactions in foreign countries.
• Reduced risk of currency devaluation, as the value of the currency is predetermined and not subject to sudden changes.
• Improved economic coordination and cooperation between countries, as fixed exchange rates allow governments to coordinate and cooperate with one another on economic policy.

Limitations of fixed exchange rate

Fixed exchange rate systems have several limitations. These include:

• Difficulty in adjusting to changes in the external environment. Fixed exchange rates prevent governments from responding to external economic shocks, making it difficult to maintain economic stability.
• Loss of autonomy. This system requires governments to surrender their control over their currency’s supply and demand, and instead rely on the central bank or monetary authority to determine its value.
• Increased speculation. When a country’s currency is pegged to that of another country, speculators can take advantage of the situation by betting on changes in the exchange rate. This can lead to increased volatility and instability in the foreign exchange market.
• Reduced competitiveness. A fixed exchange rate may lead to an overvalued currency, which reduces a country’s export competitiveness in international markets.

Fixed exchange rate — recommended articles

Floating exchange rate system — Currency Convertibility — Monetary base — Major currencies — Buffer stock — Bank reserve requirements — Reserve ratio — Open economy — Exchange rate and inflation

References

• Garber, P. M., & Svensson, L. E. (1995). The operation and collapse of fixed exchange rate regimes. Handbook of international economics, 3, 1865-1911.
• Klein, M. W., & Shambaugh, J. C. (2006). Fixed exchange rates and trade. Journal of international Economics, 70(2), 359-383.
• Flood, R. P., & Jeanne, O. (2005). An interest rate defense of a fixed exchange rate?. Journal of International Economics, 66(2), 471-484.