What Is Fixed Exchange Rate?
A fixed exchange rate is an exchange rate regime where a currency's value is pegged to the value of another single currency, a basket of currencies, or a commodity such as gold. This approach falls under the broader category of international finance and is maintained by a country's monetary authority through direct intervention in the foreign exchange market. The primary goal of a fixed exchange rate system is to provide stability and predictability in international trade and financial transactions, often by limiting the volatility of the domestic currency against its chosen peg. A fixed exchange rate system requires the central bank to actively buy or sell foreign currency to ensure the exchange rate remains within a narrow band around the official parity.
History and Origin
The concept of fixed exchange rates has a long history, with prominent examples including the gold standard that dominated global finance for decades. Under the classical gold standard, currencies were directly convertible into a specified amount of gold, which naturally fixed exchange rates between participating countries.
A more formalized system of fixed exchange rates emerged after World War II with the Bretton Woods Agreement. In July 1944, delegates from 44 Allied nations met in Bretton Woods, New Hampshire, to establish a new international monetary system designed to promote global economic growth and stability. This agreement led to the creation of the International Monetary Fund (IMF) and the World Bank. The Bretton Woods system pegged member currencies to the U.S. dollar, which was, in turn, fixed to gold at $35 an ounce. This arrangement sought to prevent competitive currency devaluation and foster international cooperation5. The IMF was tasked with overseeing these fixed arrangements and providing short-term financial assistance to countries facing balance of payments difficulties. This system of fixed exchange rates prevailed until the early 1970s, when rising inflation and balance of payments issues in the United States led to the suspension of the dollar's convertibility to gold, effectively ending the Bretton Woods system4.
Key Takeaways
- A fixed exchange rate pegs a country's currency to another currency, a basket of currencies, or a commodity like gold.
- It aims to provide exchange rate stability, reducing uncertainty for international trade and investment.
- Maintaining a fixed exchange rate requires active intervention by the central bank in the foreign exchange market.
- Historical examples include the gold standard and the Bretton Woods system.
- Fixed exchange rates limit a country's independent monetary policy flexibility.
Formula and Calculation
A fixed exchange rate is not determined by a formula in the same way a financial ratio might be, but rather by policy decision. The "fix" is typically expressed as a direct quote (foreign currency per unit of domestic currency) or an indirect quote (domestic currency per unit of foreign currency).
For example, if a country decides to peg its currency, the local currency (LC), to the U.S. dollar (USD) at a rate of 1 USD = 7.8 LC, this becomes the target rate. The central bank must then intervene to ensure the market rate stays very close to this fixed value.
The central bank's actions to maintain the peg often involve buying or selling foreign reserves. If there is upward pressure on the domestic currency (e.g., strong demand for exports leading to an appreciating domestic currency), the central bank will sell domestic currency and buy foreign currency (e.g., USD) to increase the supply of domestic currency and prevent its appreciation. Conversely, if there is downward pressure (e.g., capital outflows leading to a depreciating domestic currency), the central bank will sell foreign currency (e.g., USD) from its reserve currency holdings and buy domestic currency to bolster its value.
Interpreting the Fixed Exchange Rate
Interpreting a fixed exchange rate involves understanding the policy commitment of the pegging country's monetary authorities. When a currency is fixed, the stated rate is the official parity, and any market fluctuations are expected to remain within a very narrow band around this rate. The stability offered by a fixed exchange rate can facilitate international trade and investment by reducing exchange rate risk for businesses. It also provides a clear anchor for inflation expectations, as the value of the domestic currency is tied to a more stable or anchor currency.
However, the interpretation also extends to recognizing the policy trade-offs. While it offers stability, a fixed exchange rate limits a country's ability to use its monetary policy independently to address domestic economic challenges, such as high inflation or unemployment. For example, if the anchor currency's central bank raises interest rates, the pegging country may feel pressure to follow suit to maintain the peg, even if higher interest rates are not suitable for its domestic economic conditions.
Hypothetical Example
Consider the hypothetical country of "Economia," which decides to peg its currency, the "Econ," to the Euro (EUR) at a rate of 1 EUR = 10 Econ. The Central Bank of Economia commits to maintaining this rate.
Suppose there is a sudden increase in foreign demand for Economia's exports. This increased demand means that foreign buyers need more Econs, driving up the value of the Econ in the foreign exchange market. If left unchecked, the Econ might appreciate to, say, 1 EUR = 9.5 Econ. To prevent this appreciation and maintain the fixed exchange rate of 1 EUR = 10 Econ, the Central Bank of Economia would intervene.
The central bank would sell Econs and buy Euros in the foreign exchange market. By increasing the supply of Econs and demanding Euros, the central bank pushes the Econ's value back towards its pegged rate. This process involves the central bank engaging in open market operations by issuing new Econs or using its existing reserves to purchase Euros. This ensures the exchange rate remains stable, providing predictability for businesses engaged in international trade with Economia.
Practical Applications
Fixed exchange rates are adopted by various countries for distinct reasons, particularly those seeking to stabilize their economies or integrate more closely with a larger trading bloc. Many smaller economies, especially those with significant trade ties to a specific larger economy, opt for a fixed exchange rate to reduce currency volatility and foster economic integration. For instance, Denmark maintains a fixed exchange rate against the Euro as part of its participation in the European Union's Economic and Monetary Union framework, aiming for exchange rate stability with its primary trading partners3.
Another application is to import monetary stability from a country with a strong, low-inflation currency. Developing economies or those with a history of high inflation might peg their currencies to a major international currency like the U.S. dollar or the Euro to gain credibility for their own monetary policy. This can help attract foreign investment by reducing the perceived currency risk. Some countries utilize a currency board arrangement, a stricter form of a fixed exchange rate, where the monetary authority is legally bound to exchange the domestic currency for a foreign reserve currency at a fixed rate, backed by 100% foreign exchange reserves.
Limitations and Criticisms
While fixed exchange rates offer stability, they come with significant limitations and criticisms. A primary drawback is the loss of independent monetary policy. When a country pegs its currency, its central bank must prioritize maintaining the peg, which often means relinquishing the ability to set interest rates or control the money supply to address domestic economic conditions. For example, if the anchor country raises interest rates to combat its own inflation, the pegging country might be forced to raise its rates, even if it is experiencing a recession and needs lower rates to stimulate its economy.
Another criticism is the vulnerability to speculation and financial crises. A fixed exchange rate can create opportunities for speculative attacks if market participants believe the central bank lacks sufficient foreign reserves to defend the peg. This was famously demonstrated with the collapse of the Bretton Woods system in the early 1970s, as mounting pressure on the U.S. dollar led to its eventual decoupling from gold2. Furthermore, maintaining a fixed rate can be challenging in the face of significant external shocks or sustained current account deficits, potentially leading to a sharp currency devaluation or an economic crisis if the peg becomes unsustainable1. This can force countries to impose capital controls or deplete their foreign currency reserves, straining their financial systems.
Fixed Exchange Rate vs. Floating Exchange Rate
The distinction between a fixed exchange rate and a floating exchange rate lies in how the currency's value is determined and managed. In a fixed exchange rate system, a government or central bank officially sets and maintains the value of its currency against another currency or a commodity, actively intervening in the foreign exchange market to uphold the peg. This provides certainty and stability for international trade and investment but reduces the country's monetary policy autonomy.
Conversely, a floating exchange rate (also known as a flexible exchange rate) is determined purely by the forces of supply and demand in the foreign exchange market, without direct government intervention to maintain a specific value. The value of the currency is allowed to fluctuate freely based on economic factors like trade balance, interest rates, inflation, and capital flows. This system offers greater monetary policy independence and can act as an automatic stabilizer for the economy, as currency depreciation can make exports cheaper and imports more expensive, helping to correct trade imbalances. However, it introduces exchange rate volatility, which can create uncertainty for businesses engaged in international transactions.
FAQs
Why do countries use fixed exchange rates?
Countries often use fixed exchange rates to achieve currency stability, reduce exchange rate risk for international trade and investment, and sometimes to combat high inflation by tying their currency to a more stable foreign currency.
What is the role of the central bank in a fixed exchange rate system?
The central bank plays a crucial role by intervening in the foreign exchange market to buy or sell foreign currency, thereby influencing the supply and demand of the domestic currency to maintain its value at the predetermined peg.
What are the main disadvantages of a fixed exchange rate?
The primary disadvantages include the loss of independent monetary policy, vulnerability to speculative attacks, and the potential for a country to deplete its foreign reserves defending an unsustainable peg.