Fixed exchange rate

Definition

A fixed exchange rate is a currency system where the value of a country's currency is tied or pegged to another major currency or a basket of currencies. This system helps maintain stability in international prices and reduces the risk of exchange rate fluctuations for trade and investment.

5 Must Know Facts For Your Next Test

1. Fixed exchange rates can provide more predictability for businesses engaged in international trade since they know the exchange rate will remain stable over time.
2. Countries with fixed exchange rates must maintain large reserves of foreign currencies to support their pegs and defend against speculation.
3. Fixed exchange rates can lead to imbalances in trade if the pegged rate does not accurately reflect the underlying economic conditions.
4. The Bretton Woods system established fixed exchange rates among major currencies after World War II, which lasted until the early 1970s when it was replaced by more flexible systems.
5. Governments may need to intervene in foreign exchange markets to maintain fixed rates, which can involve buying or selling their own currency.

Review Questions

• How does a fixed exchange rate system impact international trade?
  • A fixed exchange rate system provides stability and predictability for businesses involved in international trade because they can anticipate consistent pricing for foreign transactions. This stability reduces the risk associated with fluctuating exchange rates, making it easier for companies to plan investments and pricing strategies. However, if the fixed rate does not align with economic realities, it can create trade imbalances, leading to potential long-term issues.
• Evaluate the advantages and disadvantages of maintaining a fixed exchange rate compared to a floating exchange rate.
  • Maintaining a fixed exchange rate offers advantages such as reduced uncertainty for international trade and investment, potentially stabilizing inflation. However, it requires substantial foreign currency reserves and can lead to economic distortions if the pegged value diverges from market conditions. On the other hand, a floating exchange rate allows for automatic adjustments based on economic fundamentals but introduces volatility that can complicate trade and investment decisions.
• Discuss how external economic shocks can affect countries with fixed exchange rates and their ability to respond.
  • Countries with fixed exchange rates are particularly vulnerable to external economic shocks, such as sudden changes in commodity prices or global financial crises. When these shocks occur, maintaining the fixed rate may require significant intervention in foreign exchange markets or adjustments in domestic monetary policy. If a country lacks sufficient foreign reserves to defend its peg, it may face pressure to devalue its currency or shift to a floating system, resulting in potential economic instability and loss of investor confidence.

Related terms

floating exchange rate: A floating exchange rate is a currency system where the value of a currency is determined by market forces without direct government or central bank intervention.

currency peg: A currency peg is the practice of fixing the value of a country's currency to another major currency, maintaining a specific exchange rate.

devaluation: Devaluation is the deliberate lowering of the value of a country's currency in relation to other currencies, often implemented by the government to boost exports.