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A fixed exchange rate is an exchange rate system in which domestic currency is pegged to other currencies or gold prices. For instance, imagine a country with a fixed exchange rate system where the Euro is pegged to the US dollar at a fixed rate of €1 per USD. This means the value would remain €1 per USD over time, regardless of the exchange market’s supply and demand conditions. Maintaining this fixed exchange rate would still require government intervention.
Small developing countries usually adopt this exchange rate system. Examples of countries that adopt a fixed exchange rate system are Denmark, Brunei, Bulgaria, Qatar, Saudi Arabia, Turkmenistan, the Bahamas, Bahrain, and Barbados.
Floating vs. fixed exchange rate
Exchange rates determine the value of one currency compared to another. But how are these rates set? There are two main systems: fixed and floating exchange rates.
Fixed exchange rate: In a fixed system, a government actively pegs its currency to another strong currency, a basket of currencies, or even a commodity like gold. This peg acts as a benchmark, with the government intervening in the foreign exchange market (forex market) by buying or selling its own currency as needed to maintain this fixed rate.
Floating exchange rate: Under a floating system, market forces, primarily supply and demand, dictate the value of a currency. Imagine currencies constantly bobbing on a vast exchange rate ocean, their values influenced by factors like international trade flows, interest rates, and investor sentiment. Here, governments generally take a hands-off approach, letting the forex market determine the exchange rate. However, some countries, like Indonesia, may occasionally intervene to prevent extreme fluctuations that could harm their economy.
Factors affecting the credibility of a fixed exchange rate
The exchange rate system still requires strict policy discipline. This system requires active intervention from the central bank or government authorities. Also, implementation requires credible commitments and effective policies to maintain a fixed exchange rate.
To be credible, a country must have sufficient foreign exchange reserves. These reserves are used to intervene in the foreign exchange market, namely to absorb small exchange rate movements. The central bank buys or sells currencies so that their value does not fluctuate.
The larger the foreign exchange reserves, the more credible market intervention will be. Conversely, if the foreign exchange reserves are relatively small, interventions can be ineffective when short-term speculative attacks occur. Supply and demand in the forex market involve tremendous transaction value because it involves participants worldwide. In fact, exchange rate transactions are far greater than can be intervened by a country’s foreign exchange reserves.
Maintaining a fixed exchange rate
Central banks and monetary authorities play a crucial role in upholding a fixed exchange rate system. They intervene in the foreign exchange market (forex market) to maintain the predetermined exchange rate.
Selling currency to curb appreciation: Imagine the Euro (€) is pegged to the US dollar (USD) at a fixed rate of €1 per USD. If the Euro starts to appreciate against the USD, meaning it takes fewer Euros to buy a dollar (e.g., €0.80 per USD), this indicates an excess demand for Euros in the forex market. To prevent further appreciation and maintain the peg, the central bank will sell Euros from its reserves and buy USD. By increasing the supply of Euros in the market, they dampen the upward pressure on the exchange rate and ensure it stays close to the €1 per USD level.
Buying currency to prevent depreciation: Conversely, if the Euro depreciates against the USD (e.g., €1.20 per USD), signifying an excess supply of Euros, the central bank will intervene by buying Euros using its foreign currency reserves and selling USD. This action reduces the number of Euros circulating in the forex market, thereby boosting demand and pushing the exchange rate back towards the €1 per USD peg.
By strategically buying and selling their currency, central banks aim to create an equilibrium in the forex market, ensuring the exchange rate stays close to the predetermined fixed rate.
Implications of a fixed exchange rate
Fixed exchange rates provide greater certainty for exporters and importers. Imagine a company in a country with a Euro (€) pegged to the US dollar (USD) at €1 per USD. This business can confidently plan costs and revenue based on a stable exchange rate. Knowing the exchange rate won’t fluctuate allows for easier budgeting and pricing strategies.
Stable exchange rates can help control inflation. If the Euro remains fixed at €1 per USD, the price of imported goods from the US will be less likely to fluctuate wildly. This predictability helps businesses and consumers avoid sudden price surges for imported items.
However, fixed exchange rates restrict a central bank’s ability to adjust interest rates independently. If the domestic economy requires a different interest rate than the country pegged to, the central bank may be unable to respond effectively.
A fixed exchange rate system can be vulnerable if foreign exchange reserves are insufficient or if the central bank’s credibility weakens. Speculators might attempt to manipulate the currency, forcing the central bank to spend reserves to defend the peg.
Fixed exchange rates can lead to situations where a currency becomes overvalued or undervalued. This can create imbalances in trade flows and harm the competitiveness of domestic exporters.
Risk of overvalued/undervalued currencies
Because they do not change, the official exchange rate may be overvalued or undervalued, considering the conditions of demand in the currency market. When there is excess demand in the market, the domestic currency is undervalued because it should appreciate in value.
Conversely, when the supply is in excess, the domestic currency is overvalued because it should depreciate. In this situation, the government can buy back its currency on the foreign exchange market. Alternatively, they can devalue fixed exchange rates or limit international transactions.
Limited central bank independence due to fixed interest rate spreads
In maintaining a fixed exchange rate, the government must ensure that the spread of domestic interest rates with international interest rates is fixed. Such a system requires a credible commitment from the central bank to maintain spreads. Any deviation will affect capital flows, so the exchange rate will change.
If the domestic interest rate rises while the international interest rate is fixed, it causes an inflow of capital. Capital inflows increase the demand for local currency, driving an appreciation.
Conversely, if domestic interest rates fall but international interest rates remain, capital outflows and exchange rate depreciation result due to excess supply caused by the local currency’s sale.
Vulnerability to speculative attacks if reserves are insufficient
The central bank must intervene by buying or selling its currency to absorb slight variations in exchange rates. Given the foreign exchange market’s large transaction values , such interventions often require sizeable foreign exchange reserves.
Demand and supply come from capital inflows and outflows, as well as export and import flows. Insufficient foreign exchange reserves can destroy the system of fixed exchange rates.
Difficulty managing capital flows in a globalized economy
Capital controls are essential to support a fixed exchange rate system. It involves intervening in the inflow and outflow of capital. Capital inflow controls limit the ability of foreigners to invest in the country.
Capital inflows and outflows affect supply and demand in the forex market. Therefore, when the capital flow is more controllable, it will support the fixed exchange rate policy’s credibility.
There are various instruments to limit capital outflows and inflows. Examples are taxes and investment restrictions in the real sector or portfolio.
Advantages and disadvantages of fixed exchange rate
Fixed exchange rates offer stability and predictability in the global financial landscape. However, this system also has limitations that can impact trade, investment, and overall economic health. Let’s delve deeper into the key advantages and disadvantages of fixed exchange rates.
Advantages:
Taming import inflation: Imagine a country with a fixed exchange rate between its currency (let’s say the Euro) and the US dollar. Since the exchange rate remains constant, the cost of importing goods from the US becomes more predictable. This helps businesses budget effectively and prevents sudden price spikes for imported items, ultimately contributing to lower inflation.
Boosting investment confidence: Fixed exchange rates can make a country more attractive to foreign investors. Investors appreciate the reduced risk of currency fluctuations, which can significantly impact their returns. With a stable exchange rate, they can have greater confidence in the value of their investments over time.
Facilitating international trade: When exchange rates are fixed, businesses engaged in international trade benefit from greater certainty. They can plan and price their exports and imports with more confidence, knowing the exchange rate won’t fluctuate dramatically. This predictability can potentially encourage a more robust flow of goods and services across borders.
Disadvantages:
Trade imbalances on the horizon: Fixed exchange rates can sometimes lead to overvalued or undervalued currencies. If the Euro becomes overvalued compared to the USD, European exports might become less competitive in the global market. Conversely, an undervalued Euro could make imports cheaper, potentially leading to a trade deficit.
Limited monetary policy flexibility: Central banks play a critical role in managing a country’s economy. A fixed exchange rate system can restrict a central bank’s ability to adjust interest rates as needed. If the domestic economy requires a different interest rate than the country it’s pegged to, the central bank may be unable to respond effectively.
Capital controls: a double-edged sword: To maintain a fixed exchange rate, some countries may resort to capital controls. These are restrictions on the movement of money in and out of the country. While capital controls can help stabilize the exchange rate, they can also limit investment opportunities and hinder capital mobility, potentially hindering overall economic growth.
