Fixed exchange rate

3 key takeaways

• A fixed exchange rate stabilizes the value of a currency by pegging it to another currency, providing certainty in international trade and investment.
• It requires a central bank to maintain the fixed rate by intervening in the foreign exchange market, using reserves to buy or sell its currency as needed.
• Fixed exchange rates can help control inflation but may limit a country’s ability to conduct independent monetary policy.

What is a fixed exchange rate?

A fixed exchange rate system involves setting the value of a country’s currency relative to another major currency, a basket of currencies, or a commodity like gold. The central bank maintains this fixed value through active intervention in the foreign exchange market, buying or selling its own currency to counteract supply and demand fluctuations.

Importance of fixed exchange rates

Stability in trade and investment: Fixed exchange rates provide stability and predictability in international trade and investment. Businesses and investors are more confident in cross-border transactions when exchange rates are stable, reducing the risk associated with currency fluctuations.

Inflation control: By pegging its currency to a stable and strong foreign currency, a country can import price stability, helping to control domestic inflation. This is especially important for developing countries with histories of high inflation.

Economic discipline: A fixed exchange rate can impose economic discipline on a country, as maintaining the peg requires prudent fiscal and monetary policies to avoid depleting foreign exchange reserves.

How fixed exchange rates work

In a fixed exchange rate system, the central bank sets an official exchange rate and commits to buying or selling its currency at that rate to maintain the peg. This requires the central bank to hold substantial foreign currency reserves. If the domestic currency is under pressure to depreciate, the central bank sells foreign currency reserves to buy its own currency, supporting its value. Conversely, if the domestic currency is under pressure to appreciate, the central bank buys foreign currency, increasing the supply of its own currency.

Examples of fixed exchange rates

Hong Kong Dollar (HKD): The Hong Kong Monetary Authority maintains a fixed exchange rate of approximately 7.8 HKD to 1 USD. It achieves this by intervening in the foreign exchange market to keep the exchange rate within a narrow band around this value.

Saudi Riyal (SAR): The Saudi Riyal is pegged to the US Dollar at a rate of approximately 3.75 SAR to 1 USD. The Saudi Arabian Monetary Authority uses its foreign reserves to maintain this peg.

Chinese Yuan (CNY): Historically, China maintained a strict peg of the Yuan to the US Dollar. In recent years, China has moved to a more managed float system, allowing the Yuan to fluctuate within a narrow band while still intervening to prevent excessive volatility.

Advantages and disadvantages of fixed exchange rates

Advantages:

• Predictability: Reduces exchange rate risk, benefiting international trade and investment.
• Inflation control: Helps stabilize domestic prices by anchoring the currency to a stable foreign currency.
• Economic discipline: Encourages sound economic policies to maintain the peg.

Disadvantages:

• Loss of monetary policy autonomy: Limits the central bank’s ability to use monetary policy to address domestic economic conditions.
• Vulnerability to speculative attacks: Fixed exchange rates can be targets for speculative attacks if investors believe the peg is unsustainable.
• Requirement for large reserves: Maintaining a fixed exchange rate requires substantial foreign currency reserves, which can be costly.

Transition to floating exchange rates

Many countries have transitioned from fixed to floating exchange rate systems due to the challenges associated with maintaining a peg. A floating exchange rate system allows the currency’s value to be determined by market forces of supply and demand. This provides more flexibility in monetary policy but can lead to greater exchange rate volatility.

Related topics

To further understand the concept and implications of fixed exchange rates, consider exploring these related topics:

• Floating Exchange Rate: A system where the value of a currency is determined by market forces without direct government or central bank intervention.
• Foreign Exchange Market (Forex): The global marketplace for buying and selling currencies.
• Currency Peg: The practice of fixing a currency’s value to another currency or a basket of currencies.
• Monetary Policy: The process by which a central bank manages a country’s money supply and interest rates to achieve economic goals.

Fixed exchange rates provide stability and predictability in international transactions but require significant central bank intervention and foreign currency reserves. Exploring these related topics can provide a deeper understanding of how exchange rate systems affect global trade, investment, and economic stability.