Definition
A fixed exchange rate, also known as a pegged exchange rate, is a type of exchange rate regime where a currency’s value is fixed or pegged by the government to the value of another single currency, a basket of other currencies, or to another measure of value, such as gold. Under this system, the central bank maintains the fixed rate through direct market interventions, which involves buying or selling domestic currency on the foreign exchange market. The purpose is to maintain the country’s currency value within a very narrow band.
Phonetic
The phonetics of the keyword “Fixed Exchange Rate” are: Fixed: /fɪkst/Exchange: /ɪksˈtʃeɪndʒ/Rate: /reɪt/
Key Takeaways
- Stability and Predictability: Fixed exchange rates provide a stable environment for international trade and investment. By maintaining a particular value of a country’s currency relative to others, the risks associated with foreign exchange fluctuation is reduced, leading to a more predictable economic environment for businesses and consumers.
- Limitations on Monetary Policy: While offering stability, fixed exchange rates limit a country’s freedom to implement its monetary policies. Because the country’s central bank must constantly intervene in the foreign exchange market to maintain the rate, it may also lead to an inability to address inflation, unemployment, or other issues that could be managed through monetary policy.
- Reserve Currency Requirements: To uphold the fixed exchange rate, a country must hold ample reserves of the foreign currency against which its own is pegged. This often leads to a dependence on foreign currencies and could potentially result in economic issues if there is a shortage in reserve currency.
Importance
The importance of a fixed exchange rate in business/finance lies in its ability to stabilize the value of a country’s currency by directly fixing its exchange rate in relation to a certain measure or another currency, often the U.S. dollar or gold. This offers predictability and minimizes the risks associated with fluctuating currency values in the global market, facilitating international trade and investments. Moreover, a fixed exchange rate can effectively control inflation, providing economic stability. However, it requires significant resources and monetary controls to uphold. Therefore, the concept of fixed exchange rates is an essential tool for policymakers in maintaining financial and economic stability.
Explanation
The main purpose of a fixed exchange rate, also known as a pegged exchange rate, is to maintain a country’s currency value within a very narrow band or at a specific value against a certain currency or gold. This is typically done to stabilize the exchange rate, which can promote international trade and reduce volatility in the forex market. Mainly, governments of developing countries use a fixed exchange rate to quell fluctuating exchange rates and attract foreign investors who would otherwise be wary of exchange rate risk. When a currency is pegged, it helps to provide stability and predictability for traders and investors.A fixed exchange rate is used as a means to control inflation, ensure the stability of import and export prices, and maintain competitiveness in international export markets. By maintaining a stable exchange rate, it helps avoid potential exchange rate risks in international trade agreements and makes a country’s bonds and other financial assets more attractive. However, it’s important to point out that to uphold the fixed exchange rate, the country’s central bank must hold large reserves of the foreign currency to mitigate changes in supply and demand. It means the country’s economy must be robust enough to uphold and regulate the fixed exchange rate, which can be a significant liability if the economy suffers.
Examples
1. Hong Kong Dollar and US Dollar: In Hong Kong, the government has committed to keeping the exchange rate for its currency with the US dollar within a narrow band, attempting to keep it fixed at around 7.8 Hong Kong dollars to 1 US dollar. This policy, in effect since 1983, is meant to create a more certain business environment in Hong Kong by eliminating exchange rate risk. 2. Saudi Arabian Riyal and US Dollar: The Saudi Arabian Monetary Authority (SAMA) has pegged the exchange rate of the Saudi riyal to the U.S dollar at a rate of 3.75 riyals per one dollar since the 1980s. The rate is maintained by SAMA by adjusting the supply of the riyal in the market to counteract market pressures. This has provided a stable environment for foreign companies and investors.3. Cuban Convertible Peso and US Dollar: Until April 2021, Cuba maintained a fixed exchange rate system where the Cuban Convertible Peso (CUC) was pegged 1:1 with the US dollar (USD). However, as part of its currency unification process, Cuba eliminated the CUC, shifting entirely to the usage of the Cuban Peso (CUP), which has a quite different exchange rate. Although the CUC is no longer in existence, it served as a strong example of a fixed exchange rate system for many years.
Frequently Asked Questions(FAQ)
What is a Fixed Exchange Rate?
A Fixed Exchange Rate, also known as a pegged exchange rate, is a type of exchange rate regime where a currency’s value is fixed or pegged against the value of another single currency or a basket of other currencies.
How is a Fixed Exchange Rate maintained?
It’s maintained by a country’s Central Bank which commits itself to buy or sell its currency at a fixed price.
What is the major goal of a Fixed Exchange Rate system?
The major goal is to maintain a country’s currency value within a very narrow band. This stability often eliminates foreign exchange risk which is beneficial for international trade and investment.
Is Fixed Exchange Rate system beneficial for a country’s economy?
Yes, it can be. If maintained properly, it can provide stability, reduce inflation and boost economic growth. However, it also requires heavy reserves of foreign currency to maintain the peg and can result in economic imbalances if the peg is not at a suitable level.
What are some examples of countries with Fixed Exchange Rates?
Some countries with Fixed Exchange Rates include Saudi Arabia, Hong Kong, and the United Arab Emirates, which all peg their currencies to the U.S. Dollar.
What happens when a country can no longer maintain a Fixed Exchange Rate?
When a fixed exchange rate becomes untenable, a country may opt for a sudden devaluation of the currency, switching to a floating exchange rate, or a managed float, wherein the currency is allowed to fluctify but within certain limits.
How does a Fixed Exchange Rate differ from a Floating Exchange Rate?
A Fixed Exchange Rate is set by the government and/or the central bank. On the other hand, a Floating Exchange Rate is determined by the private market through supply and demand.
What are the potential downsides of a Fixed Exchange Rate?
The downsides include the requirement for large reserves of foreign currency to maintain the peg. It might also force a government to adjust its economy to the currency, rather than adjusting the currency to the economy.
Who decides the Fixed Exchange Rate?
The Fixed Exchange Rate is usually decided by the government or the Central Bank of a country.
Related Finance Terms
- Currency Peg
- Foreign Exchange Reserves
- Monetary Policy
- Bretton Woods System
- Devaluation
Sources for More Information
- Investopedia
- Encyclopedia Britannica
- International Monetary Fund (IMF)
- Corporate Finance Institute (CFI)
