Fixed exchange rate

Definition

A fixed exchange rate is a monetary system where a country's currency value is tied or pegged to another major currency, such as the U.S. dollar or gold. This system provides stability and predictability in international prices, facilitating trade and investment. By maintaining this fixed rate, countries aim to control inflation and provide a stable economic environment, which influences their balance of payments and overall economic performance.

5 Must Know Facts For Your Next Test

1. Countries with fixed exchange rates often face challenges in adjusting to economic shocks since they cannot freely adjust their currency value.
2. A fixed exchange rate can help reduce uncertainty in trade and investment decisions, as businesses can plan more effectively without worrying about currency fluctuations.
3. Maintaining a fixed exchange rate requires substantial foreign exchange reserves to defend the peg, especially during periods of economic stress or speculation.
4. Fixed exchange rates are often associated with countries that prioritize stability over monetary policy flexibility, leading to trade-offs in their economic management.
5. In cases of significant misalignment between the fixed rate and market conditions, countries may face pressure to adjust their peg or risk depletion of reserves.

Review Questions

• How does a fixed exchange rate influence a country's balance of payments and trade relationships?
  • A fixed exchange rate stabilizes the value of a country's currency, making international transactions predictable. This predictability encourages trade by reducing the risks associated with currency fluctuations, potentially leading to an improved balance of payments. However, if the fixed rate does not reflect market conditions, it can lead to trade imbalances and affect competitiveness in global markets.
• What are some advantages and disadvantages of maintaining a fixed exchange rate system?
  • The advantages of a fixed exchange rate system include enhanced stability in trade and investment, as well as lower inflation rates due to anchored expectations. However, the disadvantages include reduced flexibility in monetary policy, challenges in responding to economic shocks, and the need for substantial foreign reserves to maintain the peg. These trade-offs require careful consideration from policymakers regarding their economic priorities.
• Evaluate the long-term implications of adopting a fixed exchange rate for emerging economies in terms of economic growth and resilience to external shocks.
  • For emerging economies, adopting a fixed exchange rate can provide short-term stability and attract foreign investment by fostering an environment of predictability. However, over the long term, this system may hinder economic growth by limiting monetary policy flexibility needed for addressing local conditions and external shocks. If these economies face sudden shifts in global markets or capital flows, they may find themselves vulnerable due to rigidities created by maintaining the fixed rate, leading to potential crises when adjustments are necessary.

Related terms

floating exchange rate: A floating exchange rate is a currency system where the value of the currency is determined by market forces without direct government or central bank intervention.

currency peg: A currency peg is a policy in which a country ties its currency's value to another stable currency to stabilize its own currency's value in international markets.

devaluation: Devaluation is the deliberate downward adjustment of a country's currency value relative to another currency or a standard, typically used to boost exports by making them cheaper.