Fixed exchange rate
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A fixed exchange rate, sometimes called a pegged exchange rate, is also referred to as the Tag of particular Rate, which is a type of exchange rate regime where a currency's value is fixed against the value of another single currency, to a basket of other currencies, or to another measure of value, such as gold.
A fixed exchange rate is usually used to stabilize the value of a currency against the currency it is pegged to. This makes trade and investments between the two countries easier and more predictable and is especially useful for small economies in which external trade forms a large part of their GDP.
It can also be used as a means to control inflation. However, as the reference value rises and falls, so does the currency pegged to it. In addition, according to the Mundell–Fleming model, with perfect capital mobility, a fixed exchange rate prevents a government from using domestic monetary policy in order to achieve macroeconomic stability.
There are no major economic players that use a fixed exchange rate (except the countries using the euro and the Chinese yuan). The currencies of the countries that now use the euro are still existing (for old bonds). The rates of these currencies are fixed with respect to the euro and to each other. The most recent such country to discontinue their fixed exchange rate was the People's Republic of China, which did so in July 2005.
Typically, a government wanting to maintain a fixed exchange rate does so by either buying or selling its own currency on the open market. This is one reason governments maintain reserves of foreign currencies. If the exchange rate drifts too far below the desired rate, the government sells its own currency in the market using its reserves. This places greater demand on the market and pushes up the price of the currency. If the exchange rate drifts too far above the desired rate, the government buys its own currency,and sells foreign currency thus reducing the pressure on demand, its foreign reserves falls.
Another, less used means of maintaining a fixed exchange rate is by simply making it illegal to trade currency at any other rate. This is difficult to enforce and often leads to a black market in foreign currency. Nonetheless, some countries are highly successful at using this method due to government monopolies over all money conversion. This was the method employed by the Chinese government to maintain a currency peg or tightly banded float against the US dollar. Throughout the 1990s, China was highly successful at maintaining a currency peg using a government monopoly over all currency conversion between the yuan and other currencies.
On 6 September 2011, the Swiss National Bank imposed a franc ceiling, for the first time in three decades, against the euro. In 1978 a franc ceiling was set versus the Deutsche Mark to stem currency gains.
The main criticism of a fixed exchange rate is that flexible exchange rates serve to adjust the balance of trade. When a trade deficit occurs, there will be increased demand for the foreign (rather than domestic) currency which will push up the price of the foreign currency in terms of the domestic currency. That in turn makes the price of foreign goods less attractive to the domestic market and thus pushes down the trade deficit. Under fixed exchange rates, this automatic rebalancing does not occur.
Governments also have to invest many resources in getting the foreign reserves to pile up in order to defend the pegged exchange rate. Moreover a government, when having a fixed rather than dynamic exchange rate, cannot use monetary or fiscal policies with a free hand. For instance, by using reflationary tools to set the economy rolling (by decreasing taxes and injecting more money in the market), the government risks running into a trade deficit. This might occur as the purchasing power of a common household increases along with inflation, thus making imports relatively cheaper.
Additionally, the stubbornness of a government in defending a fixed exchange rate when in a trade deficit will force it to use deflationary measures (increased taxation and reduced availability of money), which can lead to unemployment. Finally, other countries with a fixed exchange rate can also retaliate in response to a certain country using the currency of theirs in defending their exchange rate.
Fixed exchange rate regime versus capital control
The belief that the fixed exchange rate regime brings with it stability is only partly true, since speculative attacks tend to target currencies with fixed exchange rate regimes, and in fact, the stability of the economic system is maintained mainly through capital control. A fixed exchange rate regime should be viewed as a tool in capital control.
- Tiwari, Rajnish (2003): Post-Crisis Exchange Rate Regimes in Southeast Asia, Seminar Paper, University of Hamburg. (PDF)
Fixed or Flexible?
- Getting the Exchange Rate Right in the 1990s
- Goodman, Peter S. (2005-07-22). "China Ends Fixed-Rate Currency". Washington Post. Retrieved 2010-05-06.
- Goodman, Peter S. (2005-07-27). "Don't Expect Yuan To Rise Much, China Tells World". Washington Post. Retrieved 2010-05-06.
- Griswold, Daniel (2005-06-25). "Protectionism No Fix for China's Currency". Cato Institute. Retrieved 2010-05-06.
- Suranovic, Steven (2008-02-14). International Finance Theory and Policy. Palgrave Macmillan. p. 504.
- Caramazza, Francesco; Jahangir Aziz (April 1998). "Fixed or Flexible? - Getting the Exchange Rate Right in the 1990s". International Monetary Fund. Retrieved 2010-05-06.