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:
- Floating exchange rate
- Fixed exchange rate
- 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.
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.
Fig. 1 - Fixed exchange rate
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:
- Aruba
- The Bahamas
- Bahrain
- Hong Kong
- Iraq
- Saudi Arabia
Countries that have their currencies tied to a basket of foreign currencies instead of a single currency are:
- Libya
- Fiji
- Morocco
- 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.
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