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 tied to the value of another single currency, a basket of foreign currencies, or another measure of value, such as gold. This is done to maintain a steady value for a country’s currency. It requires the country’s central bank to hold large amounts of foreign currency to maintain the rate.
Key Takeaways
- 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 another single currency, a basket of other currencies, or to another measure of value, such as gold.
- It provides stability in the values of international transactions and reduces uncertainties for importers and exporters. In this sense, it aids in promoting international trade.
- However, maintaining a fixed exchange rate may limit a government’s monetary policy flexibility. If a currency is under or overvalued, it can lead to imbalances in the economy, such as consistent trade surpluses or deficits.
Importance
The term “Fixed Exchange Rate” is important in finance as it refers to a country’s exchange rate regime under which the government or central bank ties the official exchange rate to another country’s currency, or to the price of gold.
The purpose is to maintain the value of the currency within a narrow margin.
This stability is crucial for international trade and cross-border investment activities, as it provides predictiveness and minimizes foreign exchange risk.
It can enhance international trade, foster economic stability, control inflation, and make a country more attractive to investors by offering certainty in exchange rate fluctuations.
However, it also necessitates large reserves of foreign currency to defend the rate and may limit a country’s freedom in monetary policy.
Explanation
The primary purpose of a Fixed Exchange Rate or pegged exchange rate, is to maintain a country’s currency value within a very narrow band or at a specific value against a certain benchmark, often gold or another currency like the U.S. dollar or euro.
The primary use of this approach is to stabilize the value of a currency, thereby reducing foreign exchange rate risk, creating a predictable environment for trade, and fostering economic stability. The fixed exchange rate system works by requiring a country’s central bank to hold large amounts of reserve currency, typically the one against which they peg their own.
If their currency’s value starts to fall below the pegged rate, they will buy up their own currency in the market using their reserves to shrink the supply, drive up the price and hence maintain the peg. Conversely, if the value starts to rise above the peg, they will release more of their own currency into the market to increase supply, drive down its price, and again, stay on the peg.
This consistent, predictable value can attract foreign investment by reducing currency-related risks.
Examples of Fixed Exchange Rate
The Chinese Yuan: China has a fixed exchange rate system. Although it is not fixed to a specific value, it is controlled tightly by the country’s central bank. For many years, the yuan was pegged strictly to the U.S. dollar, but China now allows it to trade in a narrow band and has linked to a basket of currencies including the dollar, euro, yen and others, though still maintains considerable control over its value.The Hong Kong Dollar: Since 1983, Hong Kong has maintained a linked currency exchange system to the US dollar. The Hong Kong Monetary Authority ensures that for every HK$
80 in circulation, there are US$1 in reserve, which encloses the exchange rate within the band of HK$75 to HK$
85 to the US dollar.The Saudi Riyal: Saudi Arabia also maintains a fixed exchange rate, with their currency – the Saudi Riyal – pegged to the U.S. Dollar. The central bank, the Saudi Arabian Monetary Authority, ensures that the Riyal consistently trades at a rate of
75 to the U.S. Dollar. This fixed exchange rate has been maintained sinceThis kind of arrangement is common among oil-producing countries, providing stability when selling their main commodity which is often priced in U.S. dollars.
FAQs on Fixed Exchange Rate
1. What is a fixed exchange rate?
A fixed exchange rate, also known as a pegged exchange rate, is a type of exchange rate regime in which a currency’s value is matched to the value of another currency or gold. It is used to keep the value of a currency steady against the value of another currency.
2. What is the advantage of a fixed exchange rate?
A key advantage of a fixed exchange rate is that it helps to maintain low inflation, which in the long-term can keep interest rates down and stimulate economic growth. It also helps to stabilize the import/export prices between countries that have this arrangement.
3. What is the disadvantage of a fixed exchange rate?
The biggest disadvantage of a fixed exchange rate is that it may not be able to adjust to changing market conditions as quickly as a free-floating currency can. Also, maintaining a fixed exchange rate may require significant resources, like foreign exchange reserves.
4. How is a fixed exchange rate maintained?
A fixed exchange rate is maintained by a country’s central bank which intervenes in the foreign exchange market by buying or selling its currency to adjust its value according to its target exchange rate.
5. What happens if a fixed exchange rate is not maintained?
If a fixed exchange rate is not maintained, a situation can occur where there is a forced devaluation of the currency, leading to an economic crisis. This can result in inflation or a reduction in the country’s foreign exchange reserves.
Related Entrepreneurship Terms
- Pegged Currency
- Foreign Exchange Reserve
- Currency Devaluation
- Bretton Woods System
- Gold Standard
Sources for More Information
- The International Monetary Fund (IMF) – An international organization that provides financial assistance and advice to member countries. https://www.imf.org
- Investopedia – A website specializing in investment and finance education. https://www.investopedia.com
- Bank for International Settlements (BIS) – An international financial institution serving central banks in their pursuit of monetary and financial stability.
https://www.bis.org - The World Bank – An international financial institution that provides loans and grants to the countries for the purpose of pursuing capital projects.
https://www.worldbank.org
