Fixed Exchange Rate

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Last Updated:October 25, 2023

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What is the Fixed Exchange Rate?

The worth of one currency in terms of another is known as an exchange rate. In a system with fixed exchange rates, the value of one currency, a basket of currencies, or a type of monetary units, such as gold, is used to determine the exchange rate.

There are three systems to set the exchange rate;

Fixed Exchange rate system
Floating Exchange Rate System
Hybrid Exchange rate system

A fixed exchange rate system is also called a pegged exchange rate system. The main aim of using this rating system is to keep the fluctuations of the currency within a narrow range.

Following this type of system provides stability to the exporters and importers. It also assists the government in maintaining a steady inflation rate.

However, many economies started using floating exchange rates in the early 1970s.

A floating exchange rate is determined by supply and demand in the private market. It is a system in which the foreign exchange market determines a country's currency price based on supply and demand relative to other currencies.

A managed exchange rate system, also known as a hybrid exchange rate system, is a currency regime in which the exchange rate is neither completely free (or floating) nor fixed.

Rather, central bank intervention keeps the currency's value within a range against another currency (or against a basket of currencies).

The International Monetary Fund (IMF) has published an overview of exchange rate systems.

According to BBC news, Iran imposed a fixed currency rate of 42,000 rials to the American dollar in 2018 after losing 8% in a single day versus the dollar.

The government decided to close the gap between the rate maintained by traders, 60,000 rials, and the official rate, which was 37,000 at the time.

Key Takeaways

The government or central bank sets the exchange rate for the value of another currency, a basket of currencies, or other monetary units, such as gold.
The main objective of using such a system is to keep currency fluctuations within a specific range.
Central banks can gain credibility by tying their nation's currency to that of a nation with better regulation. It lessens volatility and price swings, which aids in maintaining stable inflation.
A fixed exchange rate system does not automatically rebalance the trade deficit, which is one of its main drawbacks.
The value of a country's currency is determined by the current rate on the foreign exchange market (forex) in most developed industrialized economies.

Understanding a Fixed Exchange Rate

Importers and exporters benefit from fixed rates' increased predictability. Furthermore, fixed rates help the government keep inflation low, resulting in lower interest rates.

In most advanced industrialized economies, the value of a nation's currency is determined by the going rate on the foreign exchange market.

The assumption that fixed exchange regime monetary systems provide stability is partially true because speculative attacks prefer them. Despite this, capital control plays a key role in the economic system's stability.

One should think of a pegged exchange rate system as a capital-control tool.

In light of the recent introduction of sophisticated derivatives and economic tools that allow businesses to manage risk against exchange rate volatility, the necessity of a pegged exchange rate regime has been called into question.

For these nations, this practice dates back to the early 1970s, whereas fixed-rate regimes are still used in developing economies.

The Bretton Woods Conference, also known as the United Nations Monetary and Financial Conference, took place at the Mount Washington Hotel in Bretton Woods, New York, when World War II was still in progress.

The Bretton Woods Agreement was signed by all delegates of 44 nations, which stated that the exchange rates of participating countries would be tied to the value of the US dollar, which the price of gold would determine.

The key elements of the Bretton Woods system are listed below:

International Monetary Fund (IMF)
Fixed Exchange Rate
Exchange Rate
Gold Standard
Exchange Rate Regime
Euro
Special Drawing Right
Balance of Payments
Capital Controls

The European Monetary Union (EMU) and the euro launch were preceded by establishment of the European Exchange Rate Mechanism (ERM) in 1979.

Types of Fixed Exchange Rate

The most common type of fixed exchange rate regime is the gold standard. The gold standard depends on the retail convertibility of gold. There are four main types in total, which are discussed in more detail below.

1. Gold standard

Under the gold standard, the central bank or the government decides an exchange rate of its currency for a specific weight in gold.

It will freely exchange currency for genuine gold at the predetermined exchange rate in a pure gold standard. Anyone can join the central bank and swap coins or cash for pure gold or vice versa under this "rule of exchange."

The gold standard assumes no limitations on capital movements or the export of gold by individual citizens between countries.

Since the central bank must always be ready to swap gold for coins and money on demand, it must keep gold reserves. As a result, this approach assures that currency exchange rates remain constant.

2. Price-specie flow mechanism

The price-specie flow mechanism, which functions to correct any balance of payments imbalance and adjust to shocks or changes, is the automatic adjustment mechanism under the gold standard.

This method was first proposed by Richard Cantillon and later explored by David Hume in 1752 to counter mercantilist ideas and underline that states could not amass gold indefinitely by exporting more than they imported.

The following are the mechanism's assumptions:

Prices are negotiable.
All transactions are conducted in gold.
There is a finite supply of gold around the globe. Therefore, gold coins are manufactured in each country at a defined parity.
There are no banks, and there are no capital flows.

3. Reserve currency standard

In a reserve currency regime, another country's currency serves the same tasks that gold does in a gold standard.

A state fixes the significance of its currency to one unit of another nation's currency, typically one frequently used in international trade or is a major trading partner.

4. Gold exchange standard

A gold standard similar to the one that existed between 1920 and the early 1930s served as the foundation for the post-World War II fixed exchange rate system.

A gold exchange standard combines a reserve currency and a gold standard. It has the following characteristics:

In addition to maintaining a stock of reserve currency assets, all non-reserve countries consent to fix their exchange rates to the selected reserve at a predetermined rate.
The reserve currency country ties the value of its currency to a preset weight in gold and agrees to exchange its currency for gold on demand with other central banks.

Advantages of Fixed Exchange Rate

When used by monetary authorities, the pegged system has many benefits over the other two systems.

Below, they are discussed in greater detail:

It typically stabilizes a currency's exchange rate by directly fixing its value in a pre-agreed ratio to another, more stable, pegged currency.
It eliminates exchange rate risk by lowering the uncertainty associated with it.
The exchange rate between the currency and its peg does not vary in reaction to changes in the market, in contrast to a floating exchange system. Variations in actual economic activity are therefore minimized.
This helps predict and facilitate trade and investment between the two currency zones, which is helpful for small economies that heavily rely on international trade and borrow mainly in foreign currencies.
Inflation targeting becomes easier as the currency's behavior can be influenced, but by doing so, the pegged currency will be controlled by its reference value. As a result, when the reference value rises or falls, so will the value of any currencies pegged to it.
According to the Mundell-Fleming Model, a fixed exchange rate restricts a governing party from using domestic monetary policy to attain macroeconomic stability in the case of perfect capital mobility.
Central banks can gain credibility by linking their country's currency to that of a better-regulated nation. It also decreases volatility and price swings, hence stabilizing inflation.
On a microeconomic level, a country with underdeveloped or illiquid money markets may set its exchange rates to a more liquid money market to provide credibility to its citizens.
Since countries with better inflation rates than the rest of the world are more likely to experience a recurrent balance of payments deficits and reserve losses, pegged exchange rates enforce price discipline on these countries.
Currency speculation is less unstable in a pegged exchange rate system than in a flexible one because it does not intensify variations caused by business cycles. As a result, countries' international trade and investment flows are also eased.
It prevents debt monetization of fiscal spending financed by debt purchased by the monetary authority. This prevents high inflation and imposes monetary authority discipline.

Disadvantages of Fixed Exchange Rate

Demerits of the fixed exchange rate system range from running the risk of trade deficit to being subjected to rigidness in fiscal policies. Additionally, using such a system has some drawbacks.

One of the fundamental disadvantages of a pegged exchange rate is that, unlike the floating exchange rate system, it does not automatically rebalance the trade deficit.

Suppose a trade deficit arises under a floating exchange rate. In that case, there will be a higher demand for foreign currency than the home currency, causing the price of the foreign currency to rise with the domestic currency.

As a result, the price of foreign goods becomes less appealing to the home market, lowering the trade deficit. This automated rebalancing does not occur with a pegged exchange rate.

The government risks running a trade deficit. It might happen if the purchasing power of the average household rises in conjunction with inflation, making imports relatively cheaper.

If demand for foreign reserves exceeds supply, the monetary authority may run out of foreign exchange reserves while attempting to maintain the peg. It is also known as a balance of payments or currency crisis.

When this occurs, the central bank is forced to devalue the currency. As a result, the private-sector agents will strive to protect themselves by reducing their domestic currency holdings and increasing their foreign currency holdings.

It raises the possibility of forced devaluation. A forced devaluation will affect the exchange rate more than day-to-day variations in a flexible exchange rate regime.

When an exchange rate is fixed rather than dynamic, monetary and fiscal policies cannot be used freely. However, to speed up economic growth, for instance, reflationary policies could be used (by lowering taxes and pumping more money into the market).

Furthermore, suppose a government persists in defending a pegged currency rate while running a trade deficit. In that case, it is forced to implement deflationary measures (higher taxes and decreased money availability), which can lead to unemployment.

Other nations with pegged exchange rates can respond if a specific country uses its currency to defend its exchange rate.

The declared exchange rate may differ from the market equilibrium rate, resulting in excess demand or supply. The central bank must keep supplies of both foreign and domestic currencies to regulate and maintain exchange rates and absorb excess demand or supply.

A fixed exchange rate prevents the automatic correction of imbalances in the country's balance of payments because the currency cannot increase or decrease in value in accordance with market conditions.

It needs to identify the nation's comparative advantage or disadvantage, which may result in wasteful resource allocation globally. There is a risk of policy delays and errors in establishing external balance.

The foreign exchange market bears the expense of government intervention. It could do better in countries with diverse economies and economic shocks.

How are fixed exchange rates determined

The gold standard and Bretton Woods are the two primary types of fixed exchange rate regimes. The BWS was based on central bank management, where the USD served as a sort of gold substitute, whereas the gold standard depended on the retail convertibility of gold.

Two methods are used to determine the pegged exchange rate system: open market trading and the fiat money market, which are covered in more detail below.

1. Open Market Trading

A government that wants to keep its currency at a pegged exchange rate usually does so by buying or selling it on the open market. This is one of the reasons governments hold foreign currency reserves.

If the exchange rate rises too far over a predetermined fixed rate, the government sells its currency, increasing the supply and purchasing foreign currency. As a result, the currency's value falls.

Moreover, if a country buys the currency to which its currency is pegged, the price of that currency rises, causing the currency's relative value to approach the desired relative value.

If the exchange rate falls too far below the desired level, the government sells its reserves to buy its currency in the market. It will increase market demand and lead the local currency to strengthen, eventually returning to its intended value.

2. Fiat Money Market

A less prevalent way of maintaining a fixed exchange rate is to make dealing with currency at any other rate illegal. It is tough to implement and frequently results in a foreign currency black market.

Nonetheless, due to government monopolies over all money exchange, certain countries have had great success with this strategy. The Chinese government used this strategy to maintain a currency peg or closely banded float versus the US dollar.