Fixed exchange rate

Definition

A fixed exchange rate is a currency system where a country's currency value is tied or pegged to another major currency or a basket of currencies. This system helps maintain stability in international prices and can influence trade by reducing exchange rate risk for businesses engaged in cross-border transactions.

5 Must Know Facts For Your Next Test

1. Fixed exchange rates are often maintained by central banks through interventions in the foreign exchange market to buy or sell their own currency.
2. Countries with fixed exchange rates can experience less volatility in their export prices, which may enhance trade competitiveness.
3. A key challenge of maintaining a fixed exchange rate is the risk of speculative attacks that can deplete a country's foreign reserves.
4. While fixed exchange rates can stabilize economies, they can also lead to misalignments between the market value and the pegged value of the currency.
5. Countries may adopt fixed exchange rates to signal commitment to sound economic policies and attract foreign investment.

Review Questions

• How does a fixed exchange rate system influence international trade and investment decisions for businesses?
  • A fixed exchange rate system reduces uncertainty in currency value, which can encourage international trade and investment. Businesses benefit from predictable costs in foreign transactions, allowing for more accurate pricing and budgeting. This stability can attract foreign investors who prefer reduced risk when making investment decisions, ultimately fostering economic growth.
• Discuss the advantages and disadvantages of implementing a fixed exchange rate compared to a floating exchange rate system.
  • The advantages of a fixed exchange rate include reduced volatility in trade, increased price stability, and enhanced investor confidence. However, it can also lead to challenges like reduced monetary policy flexibility and the risk of running out of foreign reserves during speculative attacks. In contrast, floating exchange rates allow for more adaptability to economic conditions but can introduce higher levels of uncertainty for businesses engaged in international trade.
• Evaluate the long-term sustainability of fixed exchange rates in response to changing global economic conditions and market dynamics.
  • The long-term sustainability of fixed exchange rates can be precarious as global economic conditions evolve. Fixed rates can lead to persistent misalignments if they do not reflect underlying economic fundamentals, making them susceptible to crises. If a country cannot maintain its peg due to external shocks or economic instability, it may have to devalue or abandon its fixed rate, leading to significant disruptions in trade and investment patterns. Policymakers must balance the benefits of stability with the risks associated with maintaining a rigid system in a dynamic global economy.

Related terms

floating exchange rate:

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

currency peg: A currency peg is the strategy of tying the value of a currency to another major currency, often used to stabilize a country's exchange rate.

devaluation: Devaluation is the reduction of the value of a country's currency in relation to other currencies, often used to correct trade imbalances.