Fixed exchange rate

Definition

A fixed exchange rate is a currency exchange system where a country's currency value is tied or pegged to another major currency, such as the US dollar or gold, maintaining a stable exchange rate over time. This system helps to provide certainty in international transactions and reduces the risk of currency fluctuations, which can affect trade and investment decisions.

5 Must Know Facts For Your Next Test

1. Countries with a fixed exchange rate often have to maintain large reserves of the foreign currency they are pegged to in order to defend the fixed rate.
2. Fixed exchange rates can provide stability for international trade but may also limit a country's ability to respond to economic shocks.
3. Adjusting a fixed exchange rate can lead to significant economic adjustments and is often politically sensitive due to its impact on inflation and employment.
4. Countries may choose to switch from a fixed to a floating exchange rate system if they face persistent balance of payments issues.
5. In some cases, countries may use a dual exchange rate system, where different rates are applied for different types of transactions, allowing for more flexibility.

Review Questions

• How does a fixed exchange rate system influence international trade compared to a floating exchange rate system?
  • A fixed exchange rate system promotes stability in international trade by providing predictable prices for goods and services exchanged between countries. This predictability reduces the risks associated with currency fluctuations, allowing businesses to plan and make investment decisions with greater confidence. In contrast, a floating exchange rate system can introduce volatility, making it harder for companies to forecast costs and revenues related to foreign transactions.
• Evaluate the advantages and disadvantages of maintaining a fixed exchange rate from a government's perspective.
  • Maintaining a fixed exchange rate can stabilize prices in international markets, reduce uncertainty for importers and exporters, and promote foreign investment by ensuring predictable currency values. However, it also restricts monetary policy options since the government must prioritize maintaining the peg over other economic objectives. This rigidity can lead to challenges if the domestic economy faces inflation or external shocks, limiting the government's ability to respond effectively.
• Assess the potential consequences of abandoning a fixed exchange rate in favor of a floating exchange rate system for an emerging market economy.
  • Abandoning a fixed exchange rate in favor of a floating system can have significant consequences for an emerging market economy. On one hand, it allows greater flexibility in monetary policy, enabling the country to respond more effectively to economic shocks and inflationary pressures. On the other hand, this transition may lead to increased volatility in currency value, which can deter foreign investment and create uncertainty in international trade. The overall impact depends on how well the economy can manage these changes and establish credibility in its new monetary policy approach.

Related terms

floating exchange rate: A floating exchange rate is a currency exchange system where the value of a currency is determined by market forces, allowing it to fluctuate freely against other currencies based on supply and demand.

currency peg: A currency peg is the process of fixing a country's exchange rate to another currency or a basket of currencies, often implemented by a government to stabilize its own currency.

Bretton Woods System: The Bretton Woods System was an international monetary system established in 1944 that set up fixed exchange rates between currencies and the US dollar, which was convertible into gold, facilitating stable economic growth.