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, such as the US dollar or gold. This system provides stability and predictability in international trade by minimizing fluctuations in exchange rates, which can affect import and export prices, investments, and overall economic stability.

5 Must Know Facts For Your Next Test

1. Countries with a fixed exchange rate system can provide greater stability for international transactions, reducing uncertainty for businesses involved in foreign trade.
2. Maintaining a fixed exchange rate requires significant reserves of foreign currency so that a country can intervene in the foreign exchange market when necessary to maintain the peg.
3. While fixed exchange rates can protect against currency fluctuations, they can also lead to imbalances if the pegged value does not reflect the true market value of the currency.
4. Some countries may choose to adopt a fixed exchange rate as a way to foster credibility in their monetary policy, particularly if they have a history of inflation or economic instability.
5. When a fixed exchange rate becomes unsustainable, it may lead to a crisis, forcing countries to either adjust the peg or transition to a floating exchange rate system.

Review Questions

• How does a fixed exchange rate impact international trade and investment compared to a floating exchange rate?
  • A fixed exchange rate provides stability and predictability, which can encourage international trade and investment by minimizing the risks associated with fluctuating exchange rates. Businesses are more likely to engage in cross-border transactions when they know that the costs of imports and exports will remain constant. In contrast, a floating exchange rate can lead to volatility that may deter investments and complicate financial planning for companies engaged in international business.
• What are some potential advantages and disadvantages of maintaining a fixed exchange rate system?
  • One advantage of a fixed exchange rate is that it provides certainty for international transactions, which can foster trade relationships and encourage foreign investment. However, disadvantages include the risk of creating imbalances if the peg does not reflect market conditions, leading to potential economic distortions. Additionally, maintaining the peg may require large reserves of foreign currency, making it challenging for countries with limited resources.
• Evaluate the reasons why some countries opt for a fixed exchange rate over a floating system in today's global economy.
  • Countries may choose a fixed exchange rate to enhance monetary policy credibility, especially in regions with histories of high inflation or economic instability. By pegging their currency to a stable major currency, they can signal commitment to stability and discipline in monetary management. Furthermore, fixed rates can simplify trade by eliminating uncertainty over exchange fluctuations. However, this approach can be risky if market conditions shift dramatically, potentially leading to financial crises if countries cannot maintain their pegs.

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 an arrangement where a country maintains its currency's value at a fixed rate to another currency or a basket of currencies.

devaluation: Devaluation is the intentional reduction of the value of a country's currency relative to other currencies, often used to boost exports by making them cheaper for foreign buyers.