What Is a Fixed Exchange Rate?
A fixed exchange rateis a regime applied by a government or central bank that ties the country's official currency exchange rate to another country's currency orthe price of gold. The purpose of a fixed exchange rate system is to keep acurrency's value within a narrow band.
Key Takeaways
- The purpose of a fixed exchange rate system is to keep acurrency's value within a narrow band.
- Fixed exchange rates provide greater certainty for exporters and importers and help the government maintain low inflation.
- Many industrialized nations began using the floating exchange rate system in the early 1970s.
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Understanding a Fixed Exchange Rate
Fixed rates provide greater certainty for exporters and importers. Fixed ratesalso help the government maintain low inflation, which, in the long run,keep interest rates downand stimulatestrade and investment.
Most major industrialized nations have had floating exchange rate systems, where the going price on the foreign exchange market (forex) sets its currency price. This practice began for these nations in the early 1970s while developing economies continue with fixed-rate systems.
Bretton Woods
From the end of World War II to the early 1970s, the Bretton Woods Agreement meant that the exchange rates of participating nations were pegged to the value of the U.S. dollar, whichwas fixedto the price of gold.
When the United States' postwar balance of payments surplus turned to a deficit in the 1950s and 1960s, the periodic exchange rate adjustments permitted under the agreement ultimately proved insufficient. In 1973, President Richard Nixon removed the United States from the gold standard, ushering in the era of floating rates.
The Beginnings of the Monetary Union
The European exchange rate mechanism (ERM)was established in 1979 as a precursor to monetary union and the introduction of the euro. Member nations, including Germany, France, the Netherlands, Belgium, and Italy, agreed to maintain their currency rates within plus or minus 2.25% of a central point.
The United Kingdom joined in October 1990 at an excessively strong conversion rate and was forced to withdraw two years later. The original members of the euro converted from their home currencies at their then-current ERM central rate as of Jan. 1, 1999. The euro itself trades freely against other major currencieswhile the currencies of countries hoping to join trade in a managed float known as ERM II.
Disadvantages of Fixed Exchange Rates
Developing economies often usea fixed-rate system to limit speculation and provide a stable system. A stable systemallows importers, exporters, and investors to plan without worrying about currency moves.
However, a fixed-rate system limits a central bank's ability to adjust interest rates as needed for economic growth. A fixed-ratesystemalso prevents market adjustments when a currency becomes over or undervalued. Effective management of a fixed-ratesystem also requires a large pool of reserves to support the currency when it is under pressure.
An unrealistic official exchange rate can also lead to the development of a parallel, unofficial, or dual, exchange rate. A large gap between official and unofficial rates can divert hard currency away from the central bank, which can lead to forex shortages and periodic large devaluations. These can be more disruptive to an economy than the periodic adjustment of a floating exchange rate regime.
Real-World Example of a Fixed Exchange Rate
Problems of a Fixed Exchange Rate Regime
In 2018, according to BBC News, Iran set a fixed exchange rate of 42,000 rials to the dollar, after losing 8% against the dollar in a single day. The government decided to remove the discrepancy between the rate traders used—60,000 rials—and the official rate, which, at the time, was 37,000.
