key term - Fixed Exchange Rate

Definition

A fixed exchange rate is a monetary policy in which a country's currency value is pegged or fixed to the value of another country's currency or to a basket of currencies. This means the exchange rate between the two currencies is predetermined and maintained by the government or central bank through intervention in the foreign exchange market.

5 Must Know Facts For Your Next Test

1. The main advantage of a fixed exchange rate is that it provides currency stability and predictability, which can promote international trade and investment.
2. Fixed exchange rates require a country's central bank to actively manage the currency's value by buying and selling its own currency on the foreign exchange market.
3. Maintaining a fixed exchange rate can be challenging, as it requires a country to give up an independent monetary policy and adjust interest rates to defend the peg.
4. Devaluation of a fixed exchange rate can occur if a country's central bank decides to lower the official value of its currency relative to other currencies.
5. Many countries have moved away from fixed exchange rates in favor of more flexible, market-determined exchange rate regimes since the collapse of the Bretton Woods system in the early 1970s.

Review Questions

• Explain how a fixed exchange rate system works and the key advantages it provides for a country's economy.
  • In a fixed exchange rate system, a country's currency value is pegged or fixed to the value of another currency or a basket of currencies. This means the exchange rate between the two currencies is predetermined and maintained by the government or central bank through intervention in the foreign exchange market. The main advantage of a fixed exchange rate is that it provides currency stability and predictability, which can promote international trade and investment by reducing exchange rate uncertainty and the risk of currency fluctuations. This stability can also help control inflation and support economic growth.
• Describe the challenges a country may face in maintaining a fixed exchange rate system and the potential consequences of devaluation.
  • Maintaining a fixed exchange rate can be challenging, as it requires a country to give up an independent monetary policy and adjust interest rates to defend the peg. If a country's economic fundamentals change, such as higher inflation or a trade deficit, the fixed exchange rate may become overvalued, leading to pressure on the currency. To maintain the peg, the central bank may need to intervene by buying or selling its own currency, which can deplete its foreign exchange reserves. As a last resort, a country may choose to devalue its currency, lowering the official value relative to other currencies. Devaluation can have significant economic consequences, such as higher import prices, increased inflation, and potential capital flight, which can undermine confidence in the currency and the economy.
• Analyze the historical trend of exchange rate regimes since the collapse of the Bretton Woods system and explain how the shift towards more flexible, market-determined exchange rates has impacted the global economy.
  • Since the collapse of the Bretton Woods system in the early 1970s, many countries have moved away from fixed exchange rates in favor of more flexible, market-determined exchange rate regimes. This shift has been driven by the increasing integration of the global economy, the need for greater monetary policy autonomy, and the challenges of maintaining a fixed exchange rate in the face of changing economic conditions. The move towards flexible exchange rates has allowed countries to better adjust to external shocks, such as changes in commodity prices or capital flows, and has provided more policy tools to manage domestic economic objectives. However, the increased exchange rate volatility associated with flexible regimes has also introduced new risks and challenges, particularly for developing economies that may lack the depth and liquidity in their foreign exchange markets. The evolution of exchange rate regimes has had significant implications for the global economy, affecting international trade, capital flows, and the stability of the international monetary system.

Related terms

Floating Exchange Rate:

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

Devaluation: Devaluation is the deliberate downward adjustment of a country's official exchange rate relative to another currency or a basket of currencies.

Pegged Exchange Rate: A pegged exchange rate is a type of fixed exchange rate system where a currency's value is matched to the value of another single currency or a basket of other currencies.