Fixed exchange rate

Definition

A fixed exchange rate is a monetary policy strategy where a country's currency value is tied or pegged to another major currency or a basket of currencies. This approach aims to maintain stability in the exchange rate, providing predictability for international trade and investment by reducing the risk of currency fluctuations. Countries with fixed exchange rates often intervene in the foreign exchange market to stabilize their currency's value.

5 Must Know Facts For Your Next Test

1. Countries with fixed exchange rates often face challenges like inflation or deflation if the pegged currency fluctuates significantly in value.
2. Central banks may need substantial foreign exchange reserves to defend the fixed exchange rate by buying or selling their own currency.
3. Fixed exchange rates can create a sense of stability, encouraging foreign investment due to reduced uncertainty regarding future currency values.
4. The system can lead to economic imbalances if the fixed rate does not reflect the true market value of the currency, potentially resulting in trade deficits.
5. In times of economic crisis, maintaining a fixed exchange rate may require drastic measures, such as increasing interest rates or implementing capital controls.

Review Questions

• How does a fixed exchange rate influence international trade and investment?
  • A fixed exchange rate provides stability and predictability for international trade and investment by minimizing risks associated with currency fluctuations. Businesses are more likely to engage in cross-border transactions when they can anticipate the future value of currencies without worrying about sudden changes. This predictability can encourage foreign direct investment since investors feel secure knowing that their returns will not be impacted by volatile exchange rates.
• Evaluate the advantages and disadvantages of maintaining a fixed exchange rate compared to a floating exchange rate system.
  • Maintaining a fixed exchange rate offers advantages such as reduced uncertainty for businesses and consumers, which can lead to increased trade and investment. However, it can also pose disadvantages, including limited flexibility to respond to economic changes and the risk of running out of foreign reserves if substantial intervention is required to maintain the peg. In contrast, a floating exchange rate allows for more automatic adjustments to economic conditions but introduces higher volatility, which can deter investment.
• Critically analyze how external economic factors can impact a country's ability to maintain a fixed exchange rate and the potential consequences of failing to do so.
  • External economic factors, such as changes in global commodity prices or shifts in major economies' monetary policies, can significantly impact a country's ability to maintain a fixed exchange rate. If these factors lead to an imbalance between supply and demand for the country's currency, it may struggle to defend its peg, potentially leading to devaluation or revaluation. Failing to maintain the fixed rate could result in loss of investor confidence, capital flight, inflationary pressures, and destabilization of the economy, creating further challenges for effective monetary policy.

Related terms

floating exchange rate: A floating exchange rate is determined by market forces without direct government or central bank intervention, allowing the currency's value to fluctuate based on supply and demand.

currency peg: A currency peg is the act of fixing the value of a currency to another currency or a basket of currencies, which is a common method used to establish a fixed exchange rate.

foreign exchange reserves: Foreign exchange reserves are the assets held by a country's central bank in foreign currencies, used to influence the exchange rate and maintain the fixed exchange rate regime.