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Fixed Exchange Rate

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Economics

Countries have many options to choose when deciding which exchange rate is best for their economy. What is the difference between the exchange rates and why does it matter? In this explanation, you will look at one of the exchange rate options that governments can implement: a fixed exchange rate.

What is a fixed exchange rate?

There are three different types of exchange rates:

  1. Floating exchange rate
  2. Fixed exchange rate
  3. Managed exchange rate

As we said, here we will focus in detail on the fixed exchange rate.

A fixed exchange rate is one where a government sets their currency against another.

When explaining a rise or fall in the value of a fixed exchange rate, we can use these two key terms: revaluation and devaluation.

Revaluation is when a government fixes a new higher exchange rate for a currency in a fixed system.

Devaluation is when a government fixes a new lower exchange rate for a currency in a fixed system.

Check out our Floating Exchange Rate explanation to understand the other two different exchange rates.

Example of a fixed exchange rate

Before discussing the example, let’s understand how a fixed exchange rate system works.

When a country opts for a fixed exchange rate, the fixed rate is determined by its central bank. This rate is then pegged to another currency. In this example, we will look at the Zimbabwean dollars and the US dollars.

The ZWL dollar was pegged to the US dollar in March. The fixed exchange rate was $1 USD to $25 ZWL.

This fixed exchange rate is known as the central peg or central rate.

The central bank would have to decide on a currency band. This band specifies the upper and lower limit, called 'ceiling' and 'floor' respectively, for the peg. The currency can now freely float so long as it is within the two bands. This is illustrated in Figure 1 below.

Fixed Exchange Rate Fixed Exchange Rate country example StudySmarterFigure 1. Fixed exchange rate - StudySmarter.

In figure 1, we can see the 'upper limit' and 'lower limit' below and above the central peg. The currency can float in between these two bands without government intervention. Once it floats above or below the limit, the central bank must intervene. The exchange rate must be brought back closer to the central peg. One way they do this is by selling or buying back their currency on the foreign exchange market.

The primary aim of fixing an exchange rate is to create stability and certainty for exporters, importers, investors, and consumers.

This was the Zimbabwean government’s aim when they pegged their currency to the US dollar. However, inflation in Zimbabwe climbed, which had an impact on their exchange rate. Soon the exchange rate was $1 US dollar to $60 ZWL dollars, and they scrapped the fixed exchange rate.

Advantages of a fixed exchange rate

There are many advantages of a fixed exchange rate. Some of these advantages were the main reason for Zimbabwe to adopt this system in the first place.

The advantages are:

  • Certainty. The stability of an exchange rate will increase both business and consumer confidence. This will encourage investment in the economy which will spur economic growth and development. Higher consumer confidence will lead to increased consumption and shift the aggregate demand (AD) curve outward.
  • Less speculation. A fixed exchange rate will have to operate within its bands to be successful. Because of this, speculation around this currency would be relatively less compared to a floating exchange rate. Less speculation reduces the concerns of the value of a currency being wiped out in a day.
  • Economic management. The wider economy can be better managed with a fixed exchange rate. It helps keep prices low, improves stability, and confidence. Having all of this in control helps a government manage the economy.

Disadvantages of a fixed exchange rate

A fixed exchange rate has disadvantages too. Some of these are the reason that caused Zimbabwe to scrap the fixed exchange rate.

The disadvantages are:

  • Inflation. Every time a devaluation of the exchange rate occurs, it can lead to cost-push inflation. Inflation can erode any competitiveness firms in the export industry may have.
  • Less freedom and flexibility. A fixed exchange rate reduces the freedom governments have to use their interest rates. Altering interest rates is a key instrument governments use to respond to shocks or to achieve other macroeconomic objectives.
  • Wrong rate. It is difficult to know which rate to fix the exchange rate at. If the rate is too high, exports will be less competitive which will impact the export sector. If the rate is too low, this will lead to inflation.

Countries with fixed exchange rates

In a fixed exchange rate system, countries can peg their currency against more than one currency as well.

Some countries which have their currency tied up to the US dollar are:

  1. Aruba
  2. The Bahamas
  3. Bahrain
  4. Hong Kong
  5. Iraq
  6. Saudi Arabia

Countries that have their currencies tied to a basket of foreign currencies instead of a single currency are:

  1. Libya
  2. Fiji
  3. Morocco
  4. Kuwait

Fixed Exchange Rate - Key takeaways

  • A fixed exchange rate is one decided by the government or the central bank based on macroeconomic policy objectives.
  • In a fixed exchange rate system, the government intervenes heavily and is constantly involved in the management of the exchange rate as opposed to the floating system.
  • The government or the central bank may decide on the target rate, as well as the ceiling (upper limit) and floor (lower limit) between which the exchange rate is allowed to move. However, it is the central bank that has the sole responsibility of monitoring and intervening to bring the rate back within the range.
  • The central bank monitors the rate by buying or selling its currency in the Forex market to influence the demand and supply. It can also manipulate the domestic interest rates.
  • The advantages of a fixed exchange rate are certainty, less speculation, and economic management.
  • The disadvantages of a fixed exchange rate are inflation, less freedom and flexibility, and setting it at the wrong rate.

Fixed Exchange Rate

The exchange rate can be fixed by either the government or its central bank. They set the rate: the upper and lower limits that the exchange rate can move between. The central bank is responsible for maintaining the exchange rate at the rate decided. 

A floating exchange rate is one that is left to float and be determined by the supply and demand of a currency on the foreign exchange market. This means that the government or any other authority doesn’t intervene. A fixed exchange rate is one that is 'fixed' or decided by the government of a country or its central bank. 

The fixed exchange rate is determined by the government or the central bank. They fix or peg the rate to another currency (like the US dollar) or a basket of currencies. The central bank is in charge of maintaining the exchange rate at the target rate. 

The fixed exchange rate is maintained by the central bank. It ensures that the exchange rate doesn't cross the upper or lower boundaries of the exchange rate band. It can either buy or sell official foreign currency reserves or increase or decrease domestic interest rates, depending on whether the exchange rate has risen higher than the ceiling rate or fallen below the floor rate. 

Final Fixed Exchange Rate Quiz

Question

What is a fixed exchange rate system? 

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Answer

A fixed exchange rate system is where the rate is fixed or set up through government intervention. Either the government or the central bank decides and sets the exchange rate. 

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Question

How is the target rate determined in a fixed exchange rate? 

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Answer

This target rate could depend on the economic goals or objectives being pursued by the government through trade or foreign exchange. 

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Question

What are the other terms for the 'target rate'?

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Answer

The exchange rate fixed by the central bank or the government is the target rate and is also called 'central peg' or 'central rate', 'parity' or 'par value'. 

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Question

What is 'ceiling' and 'floor' in a fixed exchange rate system? Explain with an example. 


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Answer

The ceiling is the upper limit while the floor is the lower limit in an exchange rate system. For example, if the government decides the central rate on 1.5 euros, the ceiling rate could be 1.55 euros while the floor rate could be 1.45 euros. 

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Question

What is the role of the foreign exchange market in a fixed exchange rate system? 

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Answer

Once the government or the central bank have fixed the exchange rate along with its upper and lower limits, it is left to fluctuate in the foreign exchange market freely. It is not tempered until it stays within the exchange rate band. 

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Question

What are two ways used to bring the exchange rate back within the exchange rate band (ceiling to floor) determined by the government or the central bank, if and when breached? 


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Answer

The two ways used are exchange equalization which is buying or selling its own currency and manipulation of the domestic interest rate in the economy.

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Question

What does the central bank do, in case of exchange equalization, if the exchange rate crosses the ceiling rate? 

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Answer

Sell its own currency

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Question

How does the central bank use its official foreign reserves if the exchange rate drops below the floor rate? 

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Answer

To bring the exchange rate above the floor rate, the central bank buys its own currency in the foreign exchange market. 

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Question

What role do the domestic interest rates play in maintaining the exchange rate in a fixed exchange rate system? 

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Answer

In the case of intervention through interest rates, if the exchange rate crosses the ceiling rate, lowering interest rates might trigger international holders of domestic currency to sell it in the Forex market. If the exchange rate drops below the floor rate, then increasing interest rates will attract investment into the country's currency and this will likely push the exchange rate up to a point where it is within the exchange rate band. 

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Question

What is the downside to using interest rates in maintaining the exchange rate in a fixed exchange rate system? 

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Answer

When interest rates are used to maintain the exchange rate in a fixed exchange rate system, they cannot be used for any other domestic macroeconomic objectives such as low unemployment or economic growth. 

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Question

State and explain two advantages of a fixed exchange rate system.

Show answer

Answer

Any two from:

  • Certainty. The stability of an exchange rate will increase both business and consumer confidence. This will encourage investment within the economy which will spur economic growth and development. Higher consumer confidence will lead to increased consumption and shift the aggregate demand (AD) curve outward.
  • Less speculation. A fixed exchange rate will have to operate within its bands if it is be successful. Because of this, speculation around this currency would be relatively less compared to it were a floating exchange rate. Less speculation reduces the concerns of the value of a currency being wiped out in a day. 
  • Economic management. The wider economy can be better managed with a fixed exchange rate. It helps keeps prices low, improves stability and confidence. Having all of this in controls, helps manage the economy.

Show question

Question

State and explain two disadvantages of a fixed exchange rate system.

Show answer

Answer

Any two from:

  • Inflation. Every time a devaluation of the exchange rate occurs, it can lead to cost push inflation. Inflation can erode any competitiveness firms in the export industry may have.
  • Less freedom and flexibility. A fixed exchange rate reduces the freedom governments have to use their interest rates. Altering interest rates is a key instrument the government use to respond to shocks, or for other macroeconomic objectives.
  • Wrong rate. It is difficult to know which rate to fix the exchange rate at. If the rate is too high, exports will be less competitive which will impact the export sector. If the rate is too low, this will lead to inflation.

Show question

Question

Name three countries with an exchange rate tied to a single currency.

Show answer

Answer

Any three from:

  1. Aruba.
  2. The Bahamas.
  3. Bahrain.
  4. Hong Kong.
  5. Iraq.
  6. Saudi Arabia. 

Show question

Question

Name two countries with an exchange rate tied to a basket of foreign currencies instead of a single currency.

Show answer

Answer

Any two from:

  1. Libya.
  2. Fiji.
  3. Morocco.
  4. Kuwait.

Show question

Question

What is the primary aim of a fixed exchange rate?

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Answer

The primary aim of fixing an exchange rate is creating stability and certainty for exporters, importers, investors and consumers.

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