Fixed vs. Pegged Exchange Rates
Both involve tying a country's currency value to another currency or a basket of currencies
What Are Fixed And Pegged Exchange Rates?
Fixed and pegged exchange rates both involve tying a country's currency value to another currency or a basket of currencies.
Fixed exchange rates are determined by governments and don't fluctuate. They are usually tied to a single currency, providing stability for international trade. This also stabilizes the exchange rate but can be challenging to sustain in the long term.
Pegged exchange rates are also fixed, tied to another currency or a basket of currencies. They can be adjusted periodically or remain fixed for extended periods, aiming to maintain economic stability and competitiveness in global markets.
Both systems aim to provide stability in international trade and investments by minimizing currency fluctuations.
Key Takeaways
- Fixed rates are constant and set by the government, providing stability but limited flexibility. Suitable for economically robust countries with stable policies.
- Pegged rates are linked to stable currencies but offer slight adjustments based on economic conditions. They balance stability with adaptability for countries needing flexibility.
- Both systems require government intervention to maintain rates. Stability is important because it promotes predictability for businesses and investors in global markets.
- The choice between fixed and pegged rates depends on a country's economic strength and the necessity for occasional adjustments, aligning with specific economic conditions and goals.
What Are Exchange Rates?
Exchange rates are the rate at which one banknote can be converted into another. The “conversion” is using one banknote (base) to buy another (quote). For example, if one US Dollar can buy 0.95 Euros (per USD), the exchange rate is 0.95 EUR/USD for the dollar holder and 1.053 USD/EUR for the Euro holder.
Each currency has a three-letter acronym used to identify them. People can compare their value and see conversion cost trends with a simple Google search. Here are some examples of these acronyms:
- Japanese Yen (JPY)
- Euro (EUR)
- Chinese Yuan/RenMinBi (CNY)
- Switzerland Franc (CHF)
- Central African Franc (XAF)
It’s important to double-check the name of the currency being converted, especially if the country in question is close to an economic union. For example, a Central African Franc is useless in Bora Bora, and Euros will get you further in Italy than in Switzerland.
These rates are important to tourists, investors, multinational corporations, hedge funds, and export-oriented industries.
Changes in the value of one currency relative to another are known as fluctuations. When the base currency buys more of the quote currency than before, it is said to have become more stronger or “appreciated.”
And when it buys less of the quote currency, it is said to have “depreciated.”
Note
Note that “depreciation” isn’t necessarily bad, and “appreciation” isn’t necessarily good. As a general rule, currency value changes can significantly distort investment returns.
What are fixed exchange rates?
Firstly, we should know that fixed rates and pegged rates are terms used interchangeably, both indicating a constant rate of exchange between a country’s currency and another currency or a basket of currencies.
In a fixed-rate system, the amount of foreign money received per unit of domestic capital is constant. This is what differentiates it from a peg. As a rule of thumb, fixed rates are stricter than pegged ones and limit the central bank’s action more.
The country maintains a constant rate of exchange with the help of its monetary policies. Its bank holds sizeable foreign currency reserves and only issues notes against them to hold their value steady concerning the foreign currency.
In such situations, the central bank has little maneuverability to address domestic economic issues because doing so affects factors that influence conversion costs. For example, interest rates affect demand and inflation, affecting the legal tender.
However, some fixed systems are even more direct, where some nations have adopted another country’s money as their legal tender. An example is the British Virgin Islands, which has adopted the US Dollar.
This process is “formal dollarization” and is used by some small tourist-driven economies to make travel easier for visitors.
Note
When a country forfeits having a legal tender to adopt another nation’s currency, that is “currency substitution.”
Currency unions arise when multiple nations share a legal tender, the Eurozone being an obvious example. The conversion cost is “specified” as one Euro in Italy equals one Euro in Greece. These unions will sometimes agree to fix their currency to another one.
A particular type of fix is the currency board, where the domestic currency is tied to that of another, more prominent country. Additionally, the ability to convert money is guaranteed, and the board is backed by law.
The IMF may recommend currency board programs to nations struggling to stabilize their economies and lend credibility to their banknotes.
What are pegged exchange rates?
Like fixed regimes, pegged regimes are also used to maintain a particular conversion cost. The significant difference is that pegged rates have some wiggle room and can change over time. As a result, pegs allow central banks more flexibility than fixed conversions.
Like the other exchange rates, central banks tasked with supporting a peg will buy and sell foreign currency reserves and issue currency. Because pegs aim to keep forex purchasing costs within certain limits, the central bank can take minor actions on economic issues whenever required.
The People’s Bank of China uses a crawling band (or crawling peg) system, which is like a regular currency band. The central bank allows the Chinese Yen (CNY) to trade in a 2% fluctuation range from a certain point.
Every day, the People’s Bank of China (PBOC) chooses a rate against the USD based on the Yuan’s previous performance and forex markets for China’s major trade partners. Hence, the band system “crawls” because it can change over time.
Pegging was widespread between 1958 and 1971 until Nixon did away with the gold standard and allowed USD to float. During that period, nations attempted to maintain a peg to the USD within a 1% band.
This was the “Bretton Woods” system, named after the July 1944 conference in Bretton Woods, New Hampshire. Delegates from Allied nations gathered to create a new international monetary system.
One of the significant outcomes of the Bretton Woods conference was a system that pegged foreign notes to the US dollar, with the value of $35 fixed to one ounce of gold.
Note
“Hard peg” refers to stricter fixed rates, while “soft peg” refers to pegged rates. “Soft pegs” have room for minor fluctuation and may be adjusted daily, weekly, or monthly. “Hard pegs” stay the same.
Fixed vs. Pegged Exchange Rates
Each system has its strengths and weaknesses. Let's see the difference between the two exchange rates by understanding the table given below:
| Aspect | Fixed Exchange Rate | Pegged Exchange Rate |
|---|---|---|
| Definition | The government sets a specific value for its currency and maintains it by buying or selling on the foreign exchange market. | The currency value is directly linked to another stable currency or a basket of currencies. |
| Flexibility | Very low flexibility; the rate remains constant unless the government decides to change it. | Offers some flexibility, as the currency value can be adjusted in response to changing economic conditions. |
| Stability | Provides stable exchange rates, promoting predictability in international trade and investments. | Offers stability but with slightly more room for adjustment, balancing stability with some adaptability. |
| Intervention | Government intervention is necessary to maintain the fixed rate. | Intervention is required to ensure the currency remains pegged to the specified value or basket of currencies. |
| Suitability | Suitable for countries with strong economic fundamentals and stable monetary policies. | Suitable for countries aiming for stability but with a need for occasional adjustments in response to economic changes. |
Researched and authored by Sara De Meyer | LinkedIn
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