Fixed Exchange Rate

Definition

A fixed exchange rate is a monetary policy in which a country's government or central bank sets and maintains the exchange rate of its currency to another currency or a basket of currencies. This means the value of the domestic currency is fixed in relation to the value of the foreign currency or currencies.

5 Must Know Facts For Your Next Test

1. A fixed exchange rate system requires the central bank to actively buy and sell its own currency to maintain the predetermined exchange rate.
2. Fixed exchange rates provide stability and predictability in international transactions, which can promote trade and investment.
3. Maintaining a fixed exchange rate can be challenging and may require a country to adjust its monetary and fiscal policies to defend the peg.
4. Fixed exchange rate systems are more common in developing economies, while advanced economies tend to favor floating exchange rate regimes.
5. The choice between a fixed or floating exchange rate regime involves tradeoffs between economic stability, policy autonomy, and exposure to external shocks.

Review Questions

• Explain how a fixed exchange rate system works and its key features.
  • In a fixed exchange rate system, the government or central bank sets and maintains the value of the domestic currency in relation to a foreign currency or a basket of currencies. This is achieved through active intervention in the foreign exchange market, where the central bank buys and sells its own currency to ensure the predetermined exchange rate is maintained. The key features of a fixed exchange rate system include stability, predictability, and the need for the central bank to adjust monetary and fiscal policies to defend the currency peg.
• Discuss the potential benefits and drawbacks of a fixed exchange rate system compared to a floating exchange rate system.
  • A fixed exchange rate system can provide stability and predictability in international transactions, which can promote trade and investment. However, maintaining a fixed exchange rate can be challenging and may require a country to sacrifice some policy autonomy, as the central bank must adjust its monetary and fiscal policies to defend the currency peg. In contrast, a floating exchange rate system allows a currency's value to be determined by market forces, providing more policy flexibility but potentially exposing the economy to greater exchange rate volatility. The choice between a fixed or floating exchange rate regime involves a tradeoff between economic stability, policy autonomy, and exposure to external shocks.
• Analyze how shifts in demand and supply in the foreign exchange market can impact a country's fixed exchange rate and the policies the government may need to implement to maintain the peg.
  • In a fixed exchange rate system, shifts in the demand and supply of a country's currency in the foreign exchange market can put pressure on the predetermined exchange rate. For example, an increase in demand for the domestic currency would put upward pressure on its value, threatening to break the peg. To maintain the fixed exchange rate, the central bank would need to intervene by selling its own currency and buying foreign currency, thereby increasing the supply of the domestic currency and defending the exchange rate target. Conversely, if there is a decrease in demand for the domestic currency, the central bank would need to buy its own currency and sell foreign currency to prevent the exchange rate from falling below the fixed level. These policy actions can require the central bank to adjust its monetary and fiscal policies, potentially leading to tradeoffs between exchange rate stability and other economic objectives.

Related terms

Floating Exchange Rate: A floating exchange rate is a regime where the currency price is set by the forex market based on supply and demand, rather than by direct government intervention.

Currency Peg: A currency peg is a monetary policy where a country's currency is fixed to another country's currency or to a basket of currencies. This is a type of fixed exchange rate system.

Exchange Rate Regime: An exchange rate regime refers to the system a country uses to manage its currency in relation to other currencies. This can be a fixed, floating, or pegged exchange rate.