Fixed Exchange Rate

A fixed exchange rate is a monetary system in which the value of a country’s currency is fixed or pegged to the value of another currency, a basket of currencies, or a commodity such as gold. Under a fixed exchange rate regime, the government or central bank of a country actively intervenes in the foreign exchange market to maintain the exchange rate at a specific level.

Here are some key features and characteristics of a fixed exchange rate:

1. Exchange Rate Stability: The primary objective of a fixed exchange rate system is to provide stability and predictability in international trade and investment. By pegging the currency to another currency or a fixed value, it reduces the volatility and uncertainty associated with fluctuating exchange rates.

2. Intervention by Central Bank: In a fixed exchange rate system, the central bank or monetary authority of a country actively intervenes in the foreign exchange market to buy or sell its currency to maintain the fixed rate. If the value of the currency is higher than the fixed rate, the central bank sells its currency to increase the supply and lower the value. Conversely, if the value is lower, the central bank buys its currency to increase demand and raise the value.

3. Monetary Policy Constraints: A fixed exchange rate regime limits the flexibility of a country’s monetary policy. Since the central bank needs to maintain the fixed rate, it may have to adjust its interest rates, money supply, and other monetary tools to align with the target exchange rate. This can restrict the ability to use monetary policy to address domestic economic conditions such as inflation or recession.

4. Balance of Payments Stability: Fixed exchange rates aim to promote stability in a country’s balance of payments by reducing currency fluctuations. It encourages confidence in international trade and investment, as businesses can plan and forecast their transactions with more certainty.

5. External Discipline: A fixed exchange rate system imposes external discipline on a country’s economic policies. To maintain the fixed rate, a country needs to have sound fiscal and monetary policies, as well as a strong balance of payments position. This can help to control inflation, maintain price stability, and promote economic stability.

6. Vulnerability to External Shocks: Fixed exchange rate regimes can make economies vulnerable to external shocks, such as changes in global economic conditions or fluctuations in commodity prices. If the fixed rate becomes misaligned with economic fundamentals, it can lead to imbalances, such as trade deficits or surpluses, and may require adjustments or devaluations.

7. Currency Convertibility: In a fixed exchange rate system, the convertibility of the currency may be restricted or controlled by the central bank or government. This is done to manage the demand for foreign currency and maintain the stability of the exchange rate.

It’s important to note that fixed exchange rate systems are less common today compared to floating exchange rate systems, where the value of a currency is determined by market forces. However, some countries still maintain fixed exchange rate regimes to achieve specific economic objectives, such as promoting export competitiveness or reducing inflation.