Learning FX

What is a Fixed Exchange Rate?

Fixed Exchange Rate for Currencies

With a fixed exchange rate, also known as a pegged exchange rate, a country will look to maintain the value of its currency at a steady level. By fixing the value of a currency against the value of either a single alternative currency, a selection of other currencies, or against the value of a commodity like gold, the exchange rate for a currency becomes fixed.

Fixed exchange rate systems compare to floating exchange rate systems, where the value of a currency is predominantly set by the level of demand for it in the foreign exchange market and is constantly varying. The UK and most of the world’s major developed economies, while they used fixed exchange rates systems in the past, now have free-floating currencies.

Fixed exchange rate systems are more often used by developing economies to bring stability to their currencies, which would otherwise fluctuate in value significantly. While they do bring stability and other benefits to a country’s economy, there are disadvantages to having a fixed exchange rate as well.

Nowadays, most countries that have a fixed exchange rate achieve this by fixing the value of it against the value of the US dollar.

Why Do Fixed Exchange Rates Exist?

As we just said, the main benefit that having a fixed exchange rate brings to a country is economic stability.

If a country has a fixed exchange rate it is much easier to invest in its economy and trade with it. Without having a fixed exchange rate, many countries which choose to have one would otherwise have highly variable currency values. The stability of a fixed exchange rate makes business and investment far more predictable, which in turn makes the country more attractive to investors and international businesses.

Another similar benefit is that, particularly in small economies, where funds are often borrowed in foreign currencies and where external trade forms a large part of the economy, having a fixed exchange rate brings stability to domestic trade done in foreign currencies. This makes domestic trade far easier to conduct.

Currency Risk

The main risk that economic and exchange rate instability brings is known as currency risk. This is the risk that a business, investor, or individual will lose out as a result of a change to the exchange rate. Typically, where a business commits to trading in a foreign currency, between the time they commit to doing so and investments or transactions actually take place, if the exchange rate changes they may lose money.

What having a fixed exchange rate does is eliminate currency risk and make flows of money in and out of a country far more predictable.

Other Advantages

As well as directly eliminating currency risk by providing a regime of fixed exchange rates, having a fixed exchange rate also brings other advantages.

One is that the effect of speculation on the currency markets is less destabilising to the country’s economy. What often happens for free-floating currencies is that fluctuations in value are brought about by business cycles and market conditions. However, while speculation does not usually cause these fluctuations, it can amplify their effect. Without it being possible to speculate on the value of a fixed currency, this effect is removed.  

Another advantage that having a fixed exchange rate brings is that, where the value of a currency is fixed against that of another currency, this is controlled by the behaviour of the currency against which it is fixed. For example, interest rates will have to be matched to those of the opposing currency to prevent the two from changing in value against one another. On top of this, levels of inflation and other currency behaviours will partly be determined by the other currency as well.  

While this behaviour control is beneficial in some instances, in others it can be limiting and can prevent the government from exerting positive controls.

What Drawbacks Do Fixed Exchange Rates Have?

Leading on from the previous point, one of the first disadvantages of fixed exchange rate systems to mention is that they limit a country’s ability to control its economy through policy changes and monetary controls. For example, if the government is forced to match interest rates to those of another currency, this prevents them from using interest rates to control the domestic economy. Interest rates, for example, can be used to manipulate the levels of foreign investment and various fiscal policies can be used to influence employment levels.

Countries with a free-floating currency have a far higher level of control over their economic policy, which can bring a number of advantages.

Balance of Payments Crisis

Another disadvantage is the potential for a balance of payments crisis.

For many currencies which are fixed against the value of another currency, the system is controlled by a country’s central bank. This central bank will buy and sell its own currency in order to maintain the exchange rate between its own currency and the currency against which it is pegged. For example, if the value of its own currency decreases it will buy it up and store it in reserves. This brings about a lack of availability of the currency, which in turn increases demand for it and its price.

What can happen in a fixed exchange rate system is that the country’s central bank can run out of foreign exchange reserves and become unable to maintain the necessary balance. This in turn causes a forced devaluation of the currency, which can cause a significant unwanted change in its value.  

How Do Fixed Exchange Rates Work?

There are various systems under which a fixed exchange rate can be maintained.

Reserve Currency Standard

The most common system of fixed exchange rates in operation around the world today is the reserve currency standard. This is the system whereby the value of a currency is fixed against the value of another currency or a selection of other currencies.

What happens is that the country sets an exchange rate for its currency against the foreign currency which it is pegging itself against and then maintains that exchange rate. The country’s central bank then buys up reserves of the foreign currency and uses those to guarantee the exchange rate by offering an exchange of domestic currency for the foreign currency at the set rate.

On top of this, they also need to buy and sell foreign and domestic currency in order to maintain the exchange rate. As we said earlier, if the value of the domestic currency is seen to be decreasing, for example, they will buy up reserves of it. This will increase the price again and maintain the targeted exchange rate.

The Gold Standard

The most simple and stable method of achieving a fixed exchange rate is with the gold standard. Under this system, rather than guaranteeing to exchange the domestic currency for a set amount of foreign currency, the government will guarantee to exchange it for a set amount (weight) of gold.

As a result, the value of a currency is permanently fixed against the value of gold, which remains relatively stable.

One disadvantage to the gold standard system is that the government is required to buy up large reserves of gold in order to maintain the system.

The Gold Exchange Standard

The gold exchange standard system is similar to the gold standard system but can be used by a group of countries.

Under this system, one currency known as the reserve currency will fix its value against the value of gold. It will then agree with all of the central banks of the countries which are taking part in the system to exchange its currency for a set amount of gold.

The participating countries then set the exchange rate for their currency against the reserve currency at a fixed level. Following on from this, they store reserves of the reserve currency, which they can exchange for gold as required. This system links all of the participating countries together and fixes their exchange rates.

The gold exchange standard system was the system that was in place for many of the largest economies in the world, including the UK, after World War II and up until the early 1970s. The system eventually collapsed and was replaced by the free-floating system that is in operation for many of those countries today.

Hybrid Exchange Rate Regimes

What has developed nowadays in many instances are hybrid systems. These systems have been developed to allow for a balance to be struck between having the stability of having a fixed currency and having the advantages of a free-floating currency.

One example is the crawling peg system. Under this system, a currency’s value is fixed against another currency but is periodically adjusted according to the markets. What this system does is prevent the high level of variability without imposing the need for a government to control exchange rates to the same extent as they do with a completely fixed exchange rate.

Other hybrid exchange rates systems are known as currency substitution systems, currency boards systems, pegged within band systems, and a basket of currencies systems.

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