Fixed exchange rate

Definition

A fixed exchange rate is a currency exchange rate that is tied or pegged to another major currency or a basket of currencies. This system aims to maintain stable exchange rates, reduce uncertainty in international transactions, and create a predictable environment for international trade and investment. By fixing the exchange rate, countries can influence their trade balance and economic stability while limiting the effects of market volatility.

5 Must Know Facts For Your Next Test

1. Countries with fixed exchange rates often need to maintain large reserves of foreign currency to defend the peg against market pressures.
2. The stability provided by fixed exchange rates can encourage foreign investment and economic growth by reducing the risk associated with currency fluctuations.
3. Fixed exchange rate systems can lead to economic imbalances if a country cannot adjust its currency value in response to changes in its economy or trading partners.
4. When a fixed exchange rate becomes unsustainable, it may result in a forced devaluation or abandonment of the peg, leading to significant economic disruptions.
5. Many developing countries adopt fixed exchange rates as a way to stabilize their economies and promote confidence in their monetary systems.

Review Questions

• How does a fixed exchange rate impact international trade and investment decisions?
  • A fixed exchange rate creates stability in currency values, which significantly impacts international trade and investment decisions. By minimizing fluctuations in exchange rates, businesses can better predict costs and revenues, leading to more confident investment decisions. This stability often attracts foreign investment, as investors feel more secure in their returns when exchange rates do not vary unpredictably.
• Compare and contrast fixed and floating exchange rate systems in terms of their advantages and disadvantages.
  • Fixed exchange rate systems offer stability and predictability, which benefits international trade by reducing uncertainty. However, they require substantial foreign reserves to maintain the peg and can lead to economic imbalances if the currency does not adjust to market conditions. In contrast, floating exchange rates reflect market dynamics, allowing for automatic adjustments but introducing volatility that can deter investment and complicate trade relationships.
• Evaluate the long-term sustainability of fixed exchange rate regimes considering global economic conditions.
  • The long-term sustainability of fixed exchange rate regimes depends heavily on a country's economic fundamentals and global economic conditions. If a country faces persistent trade deficits or inflationary pressures, maintaining a fixed rate can become challenging without adjustments like devaluation. Additionally, external shocks such as changes in global commodity prices or shifts in investor sentiment can pressure fixed regimes. Therefore, while fixed exchange rates can provide short-term stability, they may not be sustainable without sound economic policies and sufficient reserves.

Related terms

Floating exchange rate: A floating exchange rate is determined by the market forces of supply and demand, allowing the currency value to fluctuate freely against other currencies.

Currency peg: A currency peg is a policy whereby a country's currency value is tied to another currency or a group of currencies, often used in fixed exchange rate systems.

Devaluation: Devaluation refers to a reduction in the value of a country's currency relative to others, often used to adjust the fixed exchange rate or improve competitiveness.