Where the currency of one country is linked to the currency of another country
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What is a Fixed Exchange Rate?
A fixed exchange rate is an exchange rate where the currency of one country is linked to the currency of another country or a commonly traded commodity like gold or oil. Nowadays, countries usually link their currencies to their trading partners like the United States dollar.
For example, the United Arab Emirates pegs its currency, the UAE dirham, to 0.27 United States dollar. In other words, for 1 USD, you will always get 3.67 dirhams. It was done to provide stability in the oil trade between the two countries.
Summary
- A fixed exchange rate is an exchange rate where the currency of one country is linked to the currency of another country or a commonly traded commodity so they can trade freely and smoothly with each other.
- The main issue with fixed exchange rates is that it limits a central bank’s ability to adjust interest rates to affect a country’s growth rate.
- A fixed exchange rate can be maintained if the two countries ensure strict capital controls.
Advantages of a Fixed Exchange Rate
- Setting a fixed exchange rate with your trading partner will provide currency rate certainty to importers and exporters.
- When a small country fixes its currency to a superpower like the United States and the European Union, they protect themselves from paying more when importing products from the developed countries. This appreciation happens when the U.S. economy grows, which strengthens the dollar, thereby making it expensive for the smaller countries to import. Hence, a fixed exchange rate hedges them from such a risk.
- A fixed exchange rate helps to ensure the smooth flow of money from one country to another. It helps smaller and less developed countries to attract foreign investment. It also helps the smaller countries to avoid devaluation of their currency and keep inflation stable.
Disadvantages of a Fixed Exchange Rate
- In a floating exchange rate, when the trade account deficit increases, the country needs to borrow more of the foreign currency. Hence, the price of the foreign currency goes up, which also pushes the price of foreign goods up in the domestic market. It reduces the demand for the foreign goods and brings down the trade deficit. However, this rebalancing is not possible in the case of a fixed exchange rate.
- Fixed exchange rates will limit the central banks’ freedom to make adjustments to the interest rates to boost the economy.
Capital Market Arbitrage
A floating exchange rate helps the central bank to ensure the stability of the economy, as it is not bound by any rules to maintain the exchange rate. Also, with a floating rate, the money supply can be used to its best use.
When the money moves freely between countries, the issue with adopting a fixed interest rate is that the country linking its currency needs to conduct its monetary policy similar to the reference country. It also means that the interest rates need to be similar to maintain the fixed exchange rate. If it doesn’t happen, the country with the low interest rate will push its money supply to the country with the higher interest rate until the interest rates become equal again. Such a phenomenon is called capital market arbitrage.
For example, suppose the Reserve Bank of India (RBI) wants to link the Indian rupee to the United States dollar. The main objective of the RBI is to maintain the stability of its prices. If inflation starts to rise in India, then the RBI would want to increase the interest rates to control the price rise.
Since the Indian rupee is linked to the United States dollar, the RBI would need to keep the rates similar to the U.S. However, to control inflation, India increases its interest rates. The move makes the Indian rupee more attractive, and money flows from the U.S. to India.
To meet the demand of the Indian rupee, the RBI will increase the supply of its currency. However, the increase in money supply will lead to inflation, which goes against the main objective of the RBI.
Hence, when the movement of money between countries is smooth, it is best to either adopt a floating rate or set a rate domestically, but not both.
Fixed exchange rates are best for countries with similar macro-economic factors and have the same economic strength; for example, the U.S. and the European Union. If countries still want to set a fixed exchange rate, they can maintain such a relationship without impacting their interest rates by adopting strict capital controls. They can control the inflow of foreign investment in the country and also restrict transferring funds outside the country. Doing so will help maintain stability in the exchange rates.
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FAQs
A fixed exchange rate is a regime imposed by a government or central bank which ties the official exchange rate of the country's currency with the currency of another country or the gold price. A fixed exchange rate system has the aim of keeping the value of a currency within a narrow band.
What are some arguments for fixed exchange rates? ›
Advantages of Fixed Exchange Rate System
- It ensures stability in foreign exchange that encourages foreign trade.
- There is a stability in the value of currency which protects it from market fluctuations.
- It promotes foreign investment for the country.
- It helps in maintaining stable inflation rates in an economy.
Fixed Exchange Rates: An exchange rate system where exchange rates are fixed by the central bank of each country. Floating Exchange Rates: An exchange rate system where exchange rates are determined entirely by market forces.
What is truly fixed exchange rate? ›
A fixed exchange rate, often called a pegged exchange rate, is a type of exchange rate regime in which a currency's value is fixed or pegged by a monetary authority against the value of another currency, a basket of other currencies, or another measure of value, such as gold.
What is a fixed exchange rate example? ›
For example, the United Arab Emirates pegs its currency, the UAE dirham, to 0.27 United States dollar. In other words, for 1 USD, you will always get 3.67 dirhams. It was done to provide stability in the oil trade between the two countries.
What is a fixed exchange rate for dummies? ›
A fixed exchange rate – also known as a pegged exchange rate – is a system of currency exchange in which the value of one currency is tied to another. Learn more about invoicing in foreign currencies. By pegging one currency to another, there's less fluctuation when exchanging money or trading between countries.
What are the pros and cons of a fixed exchange rate? ›
Fixed currency exchange rates pros vs. cons
| Fixed Pros | Fixed Cons |
|---|
| Enable the currency's value to remain stable | Central bank must intervene often |
| Can help lower inflation which encourages investment | Country loses monetary independence |
| The Central Bank has the power to maintain rate | Can be expensive to maintain |
A pegged rate, or fixed exchange rate, can keep a country's exchange rate low, helping with exports. Conversely, pegged rates can sometimes lead to higher long-term inflation. Maintaining a pegged exchange rate usually requires a large amount of capital reserves.
Who has fixed exchange rate? ›
| Major Fixed Currencies |
|---|
| Country | Region | Currency Name |
|---|
| Panama | Central America | Balboa |
| Qatar | Middle East | Riyal |
| Saudi Arabia | Middle East | Riyal |
10 more rowsThe two major types of fixed exchange rate regimes were the gold standard and Bretton Woods. The gold standard relied on retail convertibility of gold, while the BWS relied on central bank management where the USD stood as a sort of substitute for gold.
A currency crisis is a sudden and unexpected rapid decrease in the value of a currency. Currency crises are particularly severe in the case of a fixed exchange rate. because such crises typically force a monetary authority to abandon the fixed rate.
How does fixed exchange rate affect inflation? ›
Fixed rates provide an anchor for countries with inflationary tendencies. By maintaining a fixed rate of exchange to the dollar (or some other currency), each country's inflation rate is “anchored” to the dollar and thus will follow the policy established for the dollar.
Are exchange rates always fixed? ›
If you travel internationally, you most likely will need to exchange your own currency for that of the country you are visiting. The amount of money you'll get for a given amount of your country's currency is based on internationally determined exchange rates. Exchange rates can be either fixed or floating.
What is an advantage of a fixed exchange rate quizlet? ›
An advantage of a fixed exchange rate system is that governments are not required to constantly intervene in the foreign exchange market to maintain exchange rates within specified boundaries.
How do you explain exchange rates? ›
The exchange rate gives the relative value of one currency against another currency. An exchange rate GBP/USD of two, for example, indicates that one pound will buy two U.S. dollars. The U.S. dollar is the most commonly used reference currency, which means other currencies are usually quoted against the U.S. dollar.
What is a fixed and variable exchange rate? ›
A fixed exchange rate denotes a nominal exchange rate that is set firmly by the monetary authority with respect to a foreign currency or a basket of foreign currencies. By contrast, a floating exchange rate is determined in foreign exchange markets depending on demand and supply, and it generally fluctuates constantly.
What is the floating exchange rate? ›
What Is a Floating Exchange Rate? A floating exchange rate is a regime where the currency price of a nation is set by the forex market based on supply and demand relative to other currencies. This is in contrast to a fixed exchange rate, in which the government entirely or predominantly determines the rate.
