Fixed Exchange Rate

Definition

A fixed exchange rate is a monetary policy in which a country's government or central bank sets and maintains the exchange rate of its domestic currency to a foreign currency or a basket of currencies. This system aims to provide stability and predictability in international trade and financial transactions.

5 Must Know Facts For Your Next Test

1. In a fixed exchange rate system, the government or central bank actively intervenes in the foreign exchange market to maintain the predetermined exchange rate.
2. The fixed exchange rate is typically pegged to a major global currency, such as the U.S. dollar, the euro, or a basket of currencies.
3. Maintaining a fixed exchange rate requires the central bank to buy or sell its domestic currency to keep the exchange rate from fluctuating.
4. Fixed exchange rate systems can provide stability and predictability for international trade and investment, but they can also lead to currency overvaluation or undervaluation.
5. The choice between a fixed or floating exchange rate system is a key macroeconomic policy decision that can have significant effects on a country's economic performance.

Review Questions

• Explain how a fixed exchange rate system affects the demand and supply of a country's currency in the foreign exchange market.
  • In a fixed exchange rate system, the government or central bank actively intervenes in the foreign exchange market to maintain the predetermined exchange rate. If the domestic currency's value starts to rise above the fixed rate, the central bank will sell its domestic currency and buy foreign currency to increase the supply of the domestic currency and push its value back down to the fixed rate. Conversely, if the domestic currency's value starts to fall below the fixed rate, the central bank will buy its domestic currency and sell foreign currency to increase the demand for the domestic currency and push its value back up to the fixed rate. This intervention by the central bank is what keeps the exchange rate from fluctuating in a fixed exchange rate system.
• Describe the macroeconomic effects of a country's decision to adopt a fixed exchange rate system.
  • The decision to adopt a fixed exchange rate system can have several macroeconomic effects on a country. First, it can help stabilize the country's currency and provide predictability for international trade and investment, which can promote economic growth. However, maintaining the fixed rate can also require the central bank to hold large foreign exchange reserves, which can limit its ability to implement independent monetary policy. Additionally, if the fixed rate is set at an overvalued or undervalued level, it can lead to trade imbalances and potentially require painful adjustments in the future. The choice between a fixed or floating exchange rate system is a key policy decision that can have significant impacts on a country's overall economic performance.
• Analyze the tradeoffs a country faces when deciding between a fixed or floating exchange rate system, and explain how these tradeoffs might influence the country's choice of exchange rate regime.
  • The choice between a fixed or floating exchange rate system involves several important tradeoffs for a country. A fixed exchange rate can provide stability and predictability for international trade and investment, which can promote economic growth. However, maintaining a fixed rate requires the central bank to actively intervene in the foreign exchange market, which can limit its ability to implement independent monetary policy and respond to domestic economic conditions. Conversely, a floating exchange rate system allows the central bank more flexibility in monetary policy, but it can also lead to greater currency volatility, which can create uncertainty for businesses and investors. The optimal choice between a fixed or floating exchange rate system depends on the country's specific economic circumstances, policy priorities, and tolerance for exchange rate fluctuations. Factors such as the country's level of economic development, trade patterns, and exposure to external shocks can all influence this important macroeconomic policy decision.

Related terms

Floating Exchange Rate: A floating exchange rate is a regime where the currency price is set by the foreign exchange market based on supply and demand, without government intervention.

Currency Peg: A currency peg is a monetary policy where a country's currency is fixed to the value of another country's currency or a basket of currencies.

Foreign Exchange Market: The foreign exchange market is a global decentralized market for the trading of currencies, where participants are able to buy, sell, and exchange different currencies.