Fixed exchange rates

What Is Fixed Exchange Rates?

Fixed exchange rates represent a system within international finance where a country's monetary authority, typically its central bank, sets and maintains an official exchange rate for its currency against another major currency, a basket of currencies, or a commodity like gold. Under such a regime, the central bank actively intervenes in the foreign exchange market to ensure that the exchange rate remains stable within a very narrow band around the predetermined parity. This system stands in contrast to floating exchange rates, where market forces of supply and demand primarily determine the currency's value. The primary objective of adopting fixed exchange rates is often to provide stability and predictability for international trade and investment, especially for economies seeking to curb inflation or attract foreign capital.

History and Origin

The concept of fixed exchange rates has a long history in the global monetary system. A prominent historical example is the gold standard, under which the value of a nation's currency was directly tied to a specific quantity of gold. This system inherently created fixed exchange rates among participating countries, as each currency's gold parity determined its value relative to others.

A more recent and globally influential era of fixed exchange rates was the Bretton Woods system, established in July 1944. Representatives from 44 Allied nations convened in Bretton Woods, New Hampshire, to design a new international monetary order following World War II.¹³ The agreement established the International Monetary Fund (IMF) and the World Bank, with the IMF tasked with overseeing the system of fixed exchange rates.¹² Under Bretton Woods, currencies were pegged to the U.S. dollar, which, in turn, was convertible to gold at a fixed price of $35 per ounce.¹¹ This system aimed to foster global economic stability by preventing competitive currency devaluations, which had contributed to economic turmoil in the interwar period.¹⁰ The Bretton Woods system operated effectively for over two decades, but faced increasing pressures from U.S. balance-of-payments deficits and global economic shifts, ultimately collapsing in the early 1970s.⁹

Key Takeaways

• Fixed exchange rates involve a government or central bank setting and maintaining a specific value for its national currency against another currency, a basket of currencies, or a commodity.
• Maintaining fixed exchange rates requires constant intervention in the foreign exchange market by the central bank, often through buying or selling foreign reserves.
• The system offers predictability for international trade and investment by reducing currency risk.
• A major drawback of fixed exchange rates is the loss of an independent monetary policy, as policy tools must prioritize maintaining the peg.
• Historically, major international fixed exchange rate regimes include the gold standard and the Bretton Woods system.

Interpreting the Fixed Exchange Rate

Interpreting a fixed exchange rate primarily involves understanding the commitment of a nation's monetary authority to uphold the predetermined parity. When a country maintains fixed exchange rates, it signals a dedication to currency stability. This stability is intended to foster confidence among international investors and traders. For example, if a country's currency is pegged to the U.S. dollar, market participants expect that a certain amount of the local currency will consistently exchange for a specific amount of U.S. dollars.

To maintain this fixed value, the central bank must constantly monitor and manage its foreign exchange market operations. If the local currency faces depreciation pressure due to a balance of payments deficit or capital outflows, the central bank will sell its reserves of foreign currency and buy its own currency to support the peg. Conversely, if the local currency is appreciating, the central bank will buy foreign currency and sell its own to prevent appreciation beyond the fixed band. The size and liquidity of a country's foreign reserves are crucial indicators of its ability to defend a fixed exchange rate.

Hypothetical Example

Consider a hypothetical country, "Nation X," which decides to peg its currency, the "Xylos" (XLO), to the U.S. dollar at a rate of 1 XLO = 0.50 USD. Nation X's central bank establishes this fixed exchange rate.

Scenario 1: Demand for Xylos falls.
If, due to a decrease in exports or an increase in imports, the demand for Xylos in the foreign exchange market declines, the market price of the Xylos might start to fall below 0.50 USD. To defend the fixed exchange rate, Nation X's central bank intervenes. It sells its reserves of U.S. dollars and buys Xylos. This action increases the demand for Xylos, pushing its value back up towards the 0.50 USD peg. This intervention also reduces the money supply of Xylos, which can lead to higher domestic interest rates.

Scenario 2: Demand for Xylos rises.
Conversely, if foreign investment inflows or strong export performance increase the demand for Xylos, its market price might start to rise above 0.50 USD. To prevent appreciation, the central bank sells Xylos and buys U.S. dollars. This increases the supply of Xylos in the market, pushing its value back down to the target rate. This action also expands the domestic money supply and can lead to lower domestic interest rates. These interventions are crucial for maintaining the credibility of the fixed exchange rates system.

Practical Applications

While many major industrialized economies utilize flexible exchange rates, fixed exchange rates remain relevant for certain economies, particularly developing nations or those seeking specific policy objectives.

One common application is a currency board, an extreme form of a fixed exchange rate system where the domestic currency is fully backed by foreign reserves and issued only in exchange for a specified foreign currency. Hong Kong operates a linked exchange rate system, which functions as a currency board, where the Hong Kong dollar is pegged to the U.S. dollar within a narrow band (HK$7.75-7.85 to US$1).⁸ This system has been in place since 1983 and is considered a cornerstone of Hong Kong's monetary stability.⁷ The fixed exchange rates aim to minimize currency volatility, providing a predictable environment for its large international trade balance and foreign investment flows.⁶

Fixed exchange rates can also be adopted by countries aiming to achieve price stability and promote economic growth by importing the monetary stability of a larger, more stable economy. This can be particularly appealing for smaller economies or those with a history of high inflation.

Limitations and Criticisms

Despite their potential benefits, fixed exchange rates come with significant limitations and criticisms. A primary critique is the loss of independent monetary policy. To maintain the peg, a central bank must prioritize managing the exchange rate, often at the expense of domestic economic objectives such as controlling inflation or stimulating employment. For example, if a country with fixed exchange rates faces a recession, its central bank might be constrained from lowering interest rates to stimulate the economy if such a move would put downward pressure on the peg.

Moreover, fixed exchange rates can make an economy vulnerable to external shocks or speculative attacks. If market participants believe a country cannot sustain its fixed exchange rate, they may engage in large-scale selling of the domestic currency, forcing the central bank to deplete its foreign reserves or eventually abandon the peg. The Asian financial crisis of 1997-1998 offers a stark illustration of these vulnerabilities. Several East Asian economies, which had maintained fixed exchange rates (often pegged to the U.S. dollar), experienced severe financial turmoil when their currencies came under intense speculative pressure.⁵ The prolonged maintenance of these pegged rates at unsustainable levels was cited as a factor that encouraged external borrowing and excessive exposure to foreign exchange risk, contributing to the crisis.⁴ Countries were forced to raise interest rates sharply to defend their currencies, further exacerbating economic downturns, and some ultimately abandoned their pegs.³ In some cases, governments resorted to imposing capital controls to manage the crisis.

Fixed Exchange Rates vs. Flexible Exchange Rates

The fundamental difference between fixed exchange rates and flexible exchange rates lies in how the value of a currency is determined. Under fixed exchange rates, a government or its central bank officially sets the value of its currency relative to another currency, a basket of currencies, or a commodity, and actively intervenes in the foreign exchange market to maintain this specific rate. This provides greater certainty for international trade and investment as currency fluctuations are minimized.

In contrast, flexible exchange rates are determined by the forces of supply and demand in the foreign exchange market, without direct intervention from the central bank to control the rate. The value of the currency is allowed to float freely in response to economic factors such as interest rates, inflation, and trade flows. This system allows a country to pursue an independent monetary policy tailored to domestic economic conditions, as the exchange rate can act as a shock absorber for external imbalances. However, it introduces more currency volatility and exchange rate risk for businesses engaged in international transactions. Confusion often arises because both systems aim for economic stability, but they achieve it through different mechanisms, with fixed rates prioritizing external stability and flexible rates prioritizing internal policy autonomy.

FAQs

What is the main goal of fixed exchange rates?

The primary goal of fixed exchange rates is to provide stability and predictability for international trade and investment. By pegging its currency, a country aims to reduce exchange rate risk, encourage foreign investment, and sometimes, import monetary credibility from a more stable anchor currency.

How does a central bank maintain fixed exchange rates?

A central bank maintains fixed exchange rates by intervening in the foreign exchange market. If the domestic currency is weakening, the central bank sells its foreign currency reserves to buy its own currency, thereby increasing demand and supporting its value. If the domestic currency is strengthening, the central bank sells its own currency and buys foreign currency to prevent appreciation.

What are the disadvantages of fixed exchange rates?

A significant disadvantage of fixed exchange rates is the loss of independent monetary policy. The central bank's policy tools are largely dedicated to maintaining the peg, which limits its ability to respond to domestic economic issues like unemployment or inflation. Fixed rates can also make a country vulnerable to speculative attacks and financial crises if the peg is perceived as unsustainable.

Are any major economies still using fixed exchange rates?

While many large industrialized economies have adopted flexible exchange rates, some economies still use fixed or heavily managed exchange rate systems. A notable example is Hong Kong, which operates a linked exchange rate system pegging its currency to the U.S. dollar.² Some smaller economies or those with specific geopolitical ties also maintain fixed exchange rates.

What happened to the Bretton Woods system?

The Bretton Woods system, a post-World War II regime of fixed exchange rates pegged to the U.S. dollar (which was convertible to gold), collapsed in the early 1970s. This was largely due to persistent U.S. balance of payments deficits, which led to an oversupply of dollars internationally relative to U.S. gold reserves. In 1971, the U.S. suspended the dollar's convertibility to gold, effectively ending the system and paving the way for more widespread adoption of floating exchange rates.¹