Fixed Exchange Rate
What is Fixed Exchange Rate?
A fixed exchange rate is set and maintained by a government or central bank at a specific value against another currency.
The central bank buys or sells its currency and holds foreign reserves to defend the peg. It gives stability for trade but requires large reserves and limits independent monetary policy. Some countries have used fixed or managed exchange rates.
Fixed Exchange Rate: a worked example
Suppose Marisol pegs its currency, the mar, at 5 mars per dollar. At that pegged rate traders want to sell 50 billion mars but want to buy only 40 billion, an excess supply of 10 billion mars pushing the mar below its peg. To hold the rate, Marisol's central bank must buy the surplus 10 billion mars, and at 5 mars per dollar that costs 10 ÷ 5 = 2 billion dollars of foreign reserves. If the same pressure repeats every quarter and the bank starts with 6 billion dollars of reserves, it can defend the peg for 6 ÷ 2 = 3 quarters before the reserves run out. Its options then are devaluation, tighter monetary policy to raise domestic interest rates and attract mar buyers, or controls on capital leaving the country.
The mistake students make with fixed exchange rate
Students reverse the direction of the intervention. When a pegged currency faces downward pressure they say the central bank sells its own currency, because supporting the currency sounds like supplying more of it. The opposite holds. Defending a peg against depreciation means buying your own currency with foreign reserves, which withdraws it from the market and holds the price up. Selling your own currency defends against appreciation and builds reserves instead. Check which side of the peg the market rate sits on before writing the answer.
Fixed Exchange Rate questions
Why do countries choose a fixed exchange rate?
Predictability is the main attraction. Exporters, importers, and borrowers all know what a contract signed today will be worth when it settles, so cross-border trade and lending carry less risk. A peg to a low inflation partner also imports that partner's price discipline, which a government with a history of rapid inflation can use to make its commitment credible. The price of that stability is the stock of reserves needed to defend the rate.
Why does a fixed exchange rate limit monetary policy?
Holding a peg forces the central bank to set interest rates at whatever level keeps the currency at its target. A country wanting lower rates to fight a recession would weaken its currency and drain reserves defending the peg, so it cannot cut freely. Monetary policy ends up committed to the exchange rate rather than to domestic output and inflation. That tradeoff is why countries with pegs tend to import the monetary stance of the country they peg to.
What is the difference between a devaluation and a depreciation?
Devaluation is a deliberate policy decision to reset a pegged currency to a lower official value, announced by the government or central bank. Depreciation is a market outcome under a floating rate, where supply and demand push the currency down with no official announcement. Both make exports cheaper abroad and imports dearer at home, but only devaluation involves officials choosing a new number.
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Related terms
Common comparisons
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