A fixed exchange rate is an exchange rate system in which domestic currency is pegged to other currencies or gold prices. For instance, the rupiah exchange rate against the US dollar is fixed at Rp14,000 per USD. The value will remain Rp14,000 per USD over time, regardless of the exchange market’s supply and demand conditions. Maintaining the exchange rate still requires 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.
What is the difference between a fixed exchange rate and a floating exchange rate
A fixed exchange rate system is the opposite of a floating exchange rate system, also known as a flexible exchange rate. Both are general classifications of the exchange rate system. You’ll find a wide variety of the two systems, each with several advantages and disadvantages.
Governments will allow their currency exchange rates to move under a floating exchange rate system, following the demand-supply in the foreign exchange market.
How free the exchange rate moves depends on the exchange rate system in each country. In the United States, for example, exchange rates move freely without government intervention. Meanwhile, in Indonesia, the government intervenes in the foreign exchange market when the exchange rate moves in a direction that endangers the domestic economy.
What are the 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 for intervention in the foreign exchange market, namely to absorb small exchange rate movements. The central bank would buy or sell 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. Supply and demand in the forex market involve a 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.
How a country maintains an exchange rate fixed
Authorities and central banks usually act as interveners in the market. In some countries, the monetary authority function may still be under government control. Interventions work through supply and demand mechanisms.
The central bank keeps a fixed exchange rate by buying or selling its currency. Say, the rupiah exchange rate against the US dollar is fixed at Rp14,000 per USD. When the domestic currency appreciates to, say, Rp10,000 per USD, the market tends to experience excess demand of the local currency. Therefore, to prevent exchange rate appreciation, the central bank will sell its domestic currency reserves. By doing so, the supply of domestic currency on the forex market increases and reduces upward pressure on the exchange rate.
Conversely, when the exchange rate depreciates, for example, to Rp20,000 per USD, the market tends to experience an excess supply. The central bank will buy the domestic currency to keep the rate fixed. An increase in demand pushes the price of the local currency up.
What are the implications of a fixed exchange rate
The fixed exchange rate promotes economic stability. But, it can also be destroyed if the central bank’s credibility is weak and foreign exchange reserves are insufficient. Because exchange rates do not change over time, it provides greater certainty for exporters and importers. Say, the rupiah exchange rate against the US dollar is Rp14,000 in 2018 and 2019, so when you exchange the Rp14,000 you have in 2019, you will get 1 USD, the same as in 2018.
Fixed exchange rates also help the government keep inflation low and stimulate trade and investment. Prices of imported goods will be relatively stable, reducing inflationary pressure due to exchange rate movements.
Exchange rates may be overvalued or undervalued, and that is the norm.
Because they do not change, the official exchange rate may be overvalued or undervalued, considering the conditions of demand on 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 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.
Interest rate spreads must be fixed.
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 that 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, it causes capital outflows and exchange rate depreciation due to excess supply due to the local currency’s sale.
Intervention requires significant foreign reserves.
The central bank must intervene by buying or selling its currency to absorb slight variations in exchange rates. Such interventions often require sizeable foreign exchange reserves, considering the foreign exchange market’s large transaction values .
Demand and supply not only come from capital inflows and outflows but also export and import flow. And, insufficient foreign exchange reserves can destroy the system of fixed exchange rates.
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 on 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.
What are the advantages and disadvantages of a fixed exchange rate
Advantages of fixed exchange rates
The exchange rate continues to support economic stability because the exchange rate does not move. Import inflation is less likely to occur because the exchange rate is not depreciating. Conversely, when allowed to float, the domestic currency depreciation can make imported goods more expensive. The high price of imported goods then raises the price of domestic goods and pushes up domestic inflation.
The exchange rate remains attractive to foreign capital because it does not involve translation risk. The return on investment can be more measurable. When they invest in countries that adopt fixed exchange rates, they do not need to project future exchange rates to adjust their return rate.
Further, proponents argue that exchange rates still facilitate international trade. The adverse effects of currency depreciation and appreciation on the trade balance are avoidable. As such, it provides greater certainty for importers and exporters, thus encouraging more significant international trade.
Disadvantages of fixed exchange rates
The two main reasons some countries are leaving the fixed exchange rate system.
- Deteriorating trade balance because exchange rates may be overvalued or undervalued.
- Not all countries have sufficient foreign exchange reserves for intervention. The lack of foreign exchange reserves makes it vulnerable to speculative attacks, which can damage this system.
As I discussed earlier, fixed exchange rates require considerable reserves to maintain the currency’s value. Speculators’ attacks can destroy this system. Therefore, it is not surprising that only certain countries (mainly exporting countries such as China) can credibly adopt this policy. The bigger the foreign exchange reserves, the better the chance to maintain a fixed exchange rate.
The challenge of adopting this system purely is also getting bigger nowadays. Globalization has increased international trade and capital flows, which generate a substantial supply-demand exchange rate. So, maintaining the currency’s value will require massive intervention. And, not all countries have sufficient foreign exchange reserves.
Furthermore, determining the amount of domestic currency in the economy is relatively straightforward. This is because the central bank is the sole supplier of the local currency. When the central bank will increase and decrease the money supply, it depends on the central bank’s discretion policy and economic conditions. However, this is not the case with foreign currency. The supply of foreign currency is highly dependent on the currency reserves held by the central bank.
The central bank also lost its independence and was inflexible. They must keep the spread of domestic and overseas interest rates at a fixed level. So, when international interest rates rise, the central bank must raise interest rates, even though the economy is still contracting. The increase in domestic interest rates is to avoid capital outflows.
Conversely, when domestic economic growth is high, the central bank should raise interest rates to reduce inflationary pressures. But, for example, because the domestic currency is pegged to the US dollar, the central bank cannot automatically raise interest rates. It depends on the economic conditions in the US. Suppose the United States is experiencing a contraction, and its central bank lowers interest rates. In that case, an increase in domestic interest rates will increase capital inflows, inducing depreciation.
Finally, the fixed exchange rate reduces capital mobility. Adopting countries may control capital outflows to support a fixed exchange rate. For investors, control reduces their control over the money invested. And, capital controls can ultimately inhibit the flow of capital to its most efficient use.