Fixed exchange rate

Definition

A fixed exchange rate is a monetary system where a country's currency value is tied or pegged to another major currency or a basket of currencies, maintaining a stable exchange rate over time. This system is crucial for promoting trade stability, as it reduces the risk of exchange rate fluctuations that can affect international transactions.

5 Must Know Facts For Your Next Test

1. Countries with a fixed exchange rate must maintain large reserves of foreign currency to manage their peg and intervene in the currency market as needed.
2. Fixed exchange rates can help prevent inflationary pressures by creating a predictable environment for trade and investment, especially in developing economies.
3. In a fixed exchange rate system, the central bank is often required to adjust domestic monetary policy to maintain the pegged rate, which can limit its ability to respond to domestic economic conditions.
4. Pegging a currency can create vulnerabilities, as it may lead to overvaluation or undervaluation if the economic fundamentals change significantly.
5. Fixed exchange rates were common during the Bretton Woods system but fell out of favor in the 1970s as many countries transitioned to more flexible systems.

Review Questions

• How does a fixed exchange rate impact trade stability and economic growth for countries that adopt this system?
  • A fixed exchange rate promotes trade stability by minimizing the risk of exchange rate fluctuations, which can be particularly beneficial for countries reliant on exports. By providing predictable costs for international transactions, businesses are more likely to invest and plan for the future, fostering economic growth. However, this stability can come at the cost of limited monetary policy flexibility, as adjustments may be necessary to maintain the peg.
• Discuss the advantages and disadvantages of adopting a fixed exchange rate compared to a floating exchange rate system.
  • Adopting a fixed exchange rate can provide benefits such as reduced uncertainty in international trade and enhanced credibility for monetary policy. It helps control inflation by anchoring the currency value. However, disadvantages include vulnerability to external shocks and loss of independent monetary policy, as adjustments may be required to maintain the peg. In contrast, a floating exchange rate allows for more flexibility but introduces volatility that can complicate trade and investment decisions.
• Evaluate how fixed exchange rates relate to the Trilemma of International Finance and its implications for monetary policy coordination among countries.
  • The Trilemma of International Finance posits that countries can only achieve two out of three goals: a stable foreign exchange rate, free capital movement, and an independent monetary policy. A fixed exchange rate typically leads countries to sacrifice independent monetary policy since they must adjust it to maintain the peg. This situation complicates international monetary policy coordination because countries with fixed rates may face pressures that require alignment with their pegged currency’s performance, limiting their ability to respond independently to domestic economic conditions.

Related terms

Floating exchange rate: A floating exchange rate is a currency value that fluctuates according to the foreign exchange market and is determined by supply and demand factors.

Currency peg: A currency peg is a policy in which a country's currency value is fixed to another major currency, often used to stabilize the economy and encourage foreign investment.

Monetary policy: Monetary policy refers to the actions taken by a central bank to control the money supply and interest rates in an economy, influencing economic activity and inflation.