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📜intro to political science review

Fixed Exchange Rate System

Written by the Fiveable Content Team • Last updated September 2025
Written by the Fiveable Content Team • Last updated September 2025

Definition

A fixed exchange rate system is a monetary policy where a country's currency value is tied to the value of another country's currency or to a basket of currencies. The exchange rate is maintained within a predetermined range and the government or central bank intervenes to keep the rate from fluctuating beyond this range.

5 Must Know Facts For Your Next Test

  1. The primary goal of a fixed exchange rate system is to provide stability and predictability in international trade and investment.
  2. Fixed exchange rates can help control inflation by limiting the ability of a country's central bank to engage in expansionary monetary policy.
  3. Maintaining a fixed exchange rate requires a country to hold sufficient foreign exchange reserves to intervene in currency markets and defend the peg.
  4. Fixed exchange rate systems can be vulnerable to speculative attacks if market participants doubt the government's commitment to the peg.
  5. Transitioning from a fixed to a floating exchange rate system can be challenging and may result in significant currency fluctuations.

Review Questions

  • Explain the key features and objectives of a fixed exchange rate system.
    • A fixed exchange rate system is a monetary policy where a country's currency value is tied to the value of another currency or a basket of currencies. The primary goal of this system is to provide stability and predictability in international trade and investment. By maintaining the exchange rate within a predetermined range, fixed exchange rate systems can help control inflation and promote economic growth. However, this system requires a country to hold sufficient foreign exchange reserves to defend the currency peg, and it can be vulnerable to speculative attacks if market participants doubt the government's commitment to the fixed rate.
  • Describe the role of the Bretton Woods system in the establishment of a fixed exchange rate framework.
    • The Bretton Woods system, established in 1944, was a key international monetary framework that implemented a fixed exchange rate system. Under the Bretton Woods system, exchange rates were fixed to the US dollar, which was in turn pegged to gold. This system provided stability and predictability in international trade and investment, as countries were required to maintain their currency values within a predetermined range. The Bretton Woods system played a crucial role in the establishment and maintenance of a global fixed exchange rate framework in the post-World War II era.
  • Analyze the potential challenges and limitations of a fixed exchange rate system, particularly in the context of the Bretton Woods institutions.
    • While a fixed exchange rate system can provide stability and predictability, it also presents several challenges and limitations. Maintaining a fixed exchange rate requires a country to hold sufficient foreign exchange reserves to intervene in currency markets and defend the peg, which can be costly and limit a country's monetary policy flexibility. Additionally, fixed exchange rate systems can be vulnerable to speculative attacks if market participants doubt the government's commitment to the peg. In the context of the Bretton Woods institutions, the fixed exchange rate framework faced challenges as countries struggled to balance their domestic economic goals with the need to maintain the fixed exchange rate system. The eventual collapse of the Bretton Woods system in the early 1970s highlighted the inherent tensions and limitations of a fixed exchange rate framework in a globalized economy.