Fixed Exchange Rate
A fixed exchange rate, sometimes called a pegged exchange rate, is a type of exchange rate regime wherein a currency's value is matched to the value of another single currency or to a basket of other currencies, or to another measure of value, such as gold.
A fixed exchange rate is usually used to stabilize the value of a currency against the currency it is pegged to. This makes trade and investments between the two countries easier and more predictable, and is especially useful for small economies where external trade forms a large part of their GDP.
It can also be used as a means to control inflation. However, as the reference value rises and falls, so does the currency pegged to it. In addition, according to the Mundell-Fleming model, with perfect capital mobility, a fixed exchange rate prevents a government from using domestic monetary policy in order to achieve macroeconomic stability.
There are no major economic players that use a fixed exchange rate (except the countries using the euro and the Chinese yuan). The currencies of the countries that now use the euro are still existing (e.g. for old bonds). The rates of these currencies are fixed with respect to the euro and to each other. The most recent such country to discontinue their fixed exchange rate was the People's Republic of China, which did so in July 2005.However, as of September 2010, the fixed-exchange rate of the Chinese yuan has already increased 1.5% in the last 3 months.
Maintaining Fixed Exchange Rate
Typically, a government wanting to maintain a fixed exchange rate does so by either buying or selling its own currency on the open market. This is one reason governments maintain reserves of foreign currencies. If the exchange rate drifts too far below the desired rate, the government buys its own currency in the market using its reserves. This places greater demand on the market and pushes up the price of the currency. If the exchange rate drifts too far above the desired rate, the government sells its own currency, thus increasing its foreign reserves.
Another, less used means of maintaining a fixed exchange rate is by simply making it illegal to trade currency at any other rate. This is difficult to enforce and often leads to a black market in foreign currency. Nonetheless, some countries are highly successful at using this method due to government monopolies over all money conversion. This was the method employed by the Chinese government to maintain a currency peg or tightly banded float against the US dollar. Throughout the 1990s, China was highly successful at maintaining a currency peg using a government monopoly over all currency conversion between the yuan and other currencies.
Advantages of Fixed Exchange Rate
- Reduced risk in international trade - By maintaining a fixed rate, buyers and sellers of goods internationally can agree a price and not be subject to the risk of later changes in the exchange rate before contracts are settled. The greater certainty should help encourage investment.
- Introduces discipline in economic management - As the burden or pain of adjustment to equilibrium is thrown onto the domestic economy then governments have a built-in incentive not to follow inflationary policies. If they do, then unemployment and balance of payments problems are certain to result as the economy becomes uncompetitive.
- Fixed rates should eliminate destabilising speculation - Speculation flows can be very destabilising for an economy and the incentive to speculate is very small when the exchange rate is fixed.
Disadvantages of Fixed Exchange Rate
- No automatic balance of payments adjustment - A floating exchange rate should deal with a disequilibrium in the balance of payments without government interference, and with no effect on the domestic economy. If there is a deficit then the currency falls making you competitive again. However, with a fixed rate, the problem would have to be solved by a reduction in the level of aggregate demand. As demand drops people consume less imports and also the price level falls making you more competitive.
- Large holdings of foreign exchange reserves required - Fixed exchange rates require a government to hold large scale reserves of foreign currency to maintain the fixed rate - such reserves have an opportunity cost.
- Loss of freedom in your internal policy - The needs of the exchange rate can dominate policy and this may not be best for the economy at that point. Interest rates and other policies may be set for the value of the exchange rate rather than the more important macro objectives of inflation and unemployment.
- Fixed rates are inherently unstable - Countries within a fixed rate mechanism often follow different economic policies, the result of which tends to be differing rates of inflation. What this means is that some countries will have low inflation and be very competitive and others will have high inflation and not be very competitive. The uncompetitive countries will be under severe pressure continually and may, ultimately, have to devalue. Speculators will know this and thus creates further pressure on that currency and, in turn, government.