Fixed exchange rate
Encyclopedia
A fixed exchange rate
, sometimes called a pegged exchange rate
, is a type of exchange rate regime
wherein a currency
's value is matched to the value of another single currency or to a basket of other currencies, or to another measure of value, such as gold
.
A fixed exchange rate is usually used to stabilize the value of a currency against the currency it is pegged to. This makes trade and investments between the two countries easier and more predictable, and is especially useful for small economies where external trade forms a large part of their GDP.
It can also be used as a means to control inflation
. However, as the reference value rises and falls, so does the currency pegged to it. In addition, according to the Mundell–Fleming model, with perfect capital
mobility, a fixed exchange rate prevents a government from using domestic monetary policy
in order to achieve macroeconomic
stability.
There are no major economic players that use a fixed exchange rate (except the countries using the euro
and the Chinese yuan
). The currencies of the countries that now use the euro are still existing (e.g. for old bonds). The rates of these currencies are fixed with respect to the euro and to each other. The most recent such country to discontinue their fixed exchange rate was the People's Republic of China
, which did so in July 2005. However, as of September 2010, the fixed-exchange rate of the Chinese yuan has already increased 1.5% in the last 3 months.
Another, less used means of maintaining a fixed exchange rate is by simply making it illegal to trade currency at any other rate. This is difficult to enforce and often leads to a black market in foreign currency. Nonetheless, some countries are highly successful at using this method due to government monopolies over all money conversion. This was the method employed by the Chinese government to maintain a currency peg or tightly banded float against the US dollar. Throughout the 1990s, China was highly successful at maintaining a currency peg using a government monopoly over all currency conversion between the yuan and other currencies.
On the 6th of September 2011 the Swiss National Bank has imposed a franc ceiling versus the euro, for first time in three decades. In 1978 a franc ceiling was set versus the Deutsche Mark to stem currency gains.
. When a trade deficit occurs, there will be increased demand for the foreign (rather than domestic) currency which will push up the price of the foreign currency in terms of the domestic currency. That in turn makes the price of foreign goods less attractive to the domestic market and thus pushes down the trade deficit. Under fixed exchange rates, this automatic rebalancing does not occur.
Governments also have to invest many resources in getting the foreign reserves to pile up in order to defend the pegged exchange rate. Moreover a government, when having a fixed rather than dynamic exchange rate, cannot use monetary or fiscal policies with a free hand. For instance, by using reflationary tools to set the economy rolling (by decreasing taxes and injecting more money in the market), the government risks running into a trade deficit. This might occur as the purchasing power of a common household increases along with inflation, thus making imports relatively cheaper.
Additionally, the stubbornness of a government in defending a fixed exchange rate when in a trade deficit will force it to use deflationary measures (increased taxation and reduced availability of money) which can lead to unemployment.
Finally, other countries with a fixed exchange rate can also retaliate in response to a certain country using the currency of theirs in defending their exchange rate.
s
tend to target currencies with fixed exchange rate regimes, and in fact, the stability of the economic system is maintained mainly through capital control
. A fixed exchange rate regime should be viewed as a tool in capital control.
For instance, China has allowed free exchange for current account
transactions since December 1, 1996. Of more than 40 categories of capital account, about 20 of them are convertible. These convertible accounts are mainly related to foreign direct investment
. Because of capital control, even the renminbi
is not under the managed floating exchange rate regime, but free to float, and so it is somewhat unnecessary for foreigners to purchase renminbi.
Fixed or Flexible?
Fixed exchange rate system
A fixed exchange-rate system is a currency system in which governments try to keep the value of their currencies constant against one another....
, sometimes called a pegged exchange rate
Fixed exchange rate system
A fixed exchange-rate system is a currency system in which governments try to keep the value of their currencies constant against one another....
, is a type of exchange rate regime
Exchange rate regime
The exchange-rate regime is the way a country manages its currency in relation to other currencies and the foreign exchange market. It is closely related to monetary policy and the two are generally dependent on many of the same factors....
wherein a currency
Currency
In economics, currency refers to a generally accepted medium of exchange. These are usually the coins and banknotes of a particular government, which comprise the physical aspects of a nation's money supply...
's value is matched to the value of another single currency or to a basket of other currencies, or to another measure of value, such as gold
Gold standard
The gold standard is a monetary system in which the standard economic unit of account is a fixed mass of gold. There are distinct kinds of gold standard...
.
A fixed exchange rate is usually used to stabilize the value of a currency against the currency it is pegged to. This makes trade and investments between the two countries easier and more predictable, and is especially useful for small economies where external trade forms a large part of their GDP.
It can also be used as a means to control inflation
Inflation
In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money – a...
. However, as the reference value rises and falls, so does the currency pegged to it. In addition, according to the Mundell–Fleming model, with perfect capital
Capital (economics)
In economics, capital, capital goods, or real capital refers to already-produced durable goods used in production of goods or services. The capital goods are not significantly consumed, though they may depreciate in the production process...
mobility, a fixed exchange rate prevents a government from using domestic monetary policy
Monetary policy
Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability. The official goals usually include relatively stable prices and low unemployment...
in order to achieve macroeconomic
Macroeconomics
Macroeconomics is a branch of economics dealing with the performance, structure, behavior, and decision-making of the whole economy. This includes a national, regional, or global economy...
stability.
There are no major economic players that use a fixed exchange rate (except the countries using the euro
Euro
The euro is the official currency of the eurozone: 17 of the 27 member states of the European Union. It is also the currency used by the Institutions of the European Union. The eurozone consists of Austria, Belgium, Cyprus, Estonia, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg,...
and the Chinese yuan
Chinese yuan
The yuan is the base unit of a number of modern Chinese currencies. The yuan is the primary unit of account of the Renminbi.A yuán is also known colloquially as a kuài . One yuán is divided into 10 jiǎo or colloquially máo...
). The currencies of the countries that now use the euro are still existing (e.g. for old bonds). The rates of these currencies are fixed with respect to the euro and to each other. The most recent such country to discontinue their fixed exchange rate was the People's Republic of China
People's Republic of China
China , officially the People's Republic of China , is the most populous country in the world, with over 1.3 billion citizens. Located in East Asia, the country covers approximately 9.6 million square kilometres...
, which did so in July 2005. However, as of September 2010, the fixed-exchange rate of the Chinese yuan has already increased 1.5% in the last 3 months.
Maintenance
Typically, a government wanting to maintain a fixed exchange rate does so by either buying or selling its own currency on the open market. This is one reason governments maintain reserves of foreign currencies. If the exchange rate drifts too far below the desired rate, the government buys its own currency in the market using its reserves. This places greater demand on the market and pushes up the price of the currency. If the exchange rate drifts too far above the desired rate, the government sells its own currency, thus increasing its foreign reserves.Another, less used means of maintaining a fixed exchange rate is by simply making it illegal to trade currency at any other rate. This is difficult to enforce and often leads to a black market in foreign currency. Nonetheless, some countries are highly successful at using this method due to government monopolies over all money conversion. This was the method employed by the Chinese government to maintain a currency peg or tightly banded float against the US dollar. Throughout the 1990s, China was highly successful at maintaining a currency peg using a government monopoly over all currency conversion between the yuan and other currencies.
On the 6th of September 2011 the Swiss National Bank has imposed a franc ceiling versus the euro, for first time in three decades. In 1978 a franc ceiling was set versus the Deutsche Mark to stem currency gains.
Criticisms
The main criticism of a fixed exchange rate is that flexible exchange rates serve to automatically adjust the balance of tradeBalance of trade
The balance of trade is the difference between the monetary value of exports and imports of output in an economy over a certain period. It is the relationship between a nation's imports and exports...
. When a trade deficit occurs, there will be increased demand for the foreign (rather than domestic) currency which will push up the price of the foreign currency in terms of the domestic currency. That in turn makes the price of foreign goods less attractive to the domestic market and thus pushes down the trade deficit. Under fixed exchange rates, this automatic rebalancing does not occur.
Governments also have to invest many resources in getting the foreign reserves to pile up in order to defend the pegged exchange rate. Moreover a government, when having a fixed rather than dynamic exchange rate, cannot use monetary or fiscal policies with a free hand. For instance, by using reflationary tools to set the economy rolling (by decreasing taxes and injecting more money in the market), the government risks running into a trade deficit. This might occur as the purchasing power of a common household increases along with inflation, thus making imports relatively cheaper.
Additionally, the stubbornness of a government in defending a fixed exchange rate when in a trade deficit will force it to use deflationary measures (increased taxation and reduced availability of money) which can lead to unemployment.
Finally, other countries with a fixed exchange rate can also retaliate in response to a certain country using the currency of theirs in defending their exchange rate.
Fixed exchange rate regime versus capital control
The belief that the fixed exchange rate regime brings with it stability is only partly true, since speculative attackSpeculative attack
A speculative attack is a term used by economists to denote a precipitous acquisition of something by previously inactive speculators. The first model of a speculative attack was contained in a 1975 discussion paper on the gold market by Stephen Salant and Dale Henderson at the Federal Reserve Board...
s
tend to target currencies with fixed exchange rate regimes, and in fact, the stability of the economic system is maintained mainly through capital control
Capital control
Capital controls are measures such as transaction taxes and other limits or outright prohibitions, which a nation's government can use to regulate the flows into and out of the country's capital account....
. A fixed exchange rate regime should be viewed as a tool in capital control.
For instance, China has allowed free exchange for current account
Current account
In economics, the current account is one of the two primary components of the balance of payments, the other being the capital account. The current account is the sum of the balance of trade , net factor income and net transfer payments .The current account balance is one of two major...
transactions since December 1, 1996. Of more than 40 categories of capital account, about 20 of them are convertible. These convertible accounts are mainly related to foreign direct investment
Foreign direct investment
Foreign direct investment or foreign investment refers to the net inflows of investment to acquire a lasting management interest in an enterprise operating in an economy other than that of the investor.. It is the sum of equity capital,other long-term capital, and short-term capital as shown in...
. Because of capital control, even the renminbi
Renminbi
The Renminbi is the official currency of the People's Republic of China . Renminbi is legal tender in mainland China, but not in Hong Kong or Macau. It is issued by the People's Bank of China, the monetary authority of the PRC...
is not under the managed floating exchange rate regime, but free to float, and so it is somewhat unnecessary for foreigners to purchase renminbi.
Literature
- Tiwari, Rajnish (2003): Post-Crisis Exchange Rate Regimes in Southeast Asia, Seminar Paper, University of Hamburg. (PDF)
Fixed or Flexible?
- Getting the Exchange Rate Right in the 1990s
See also
Category:Fixed exchange rate- Fixed exchange rate systemFixed exchange rate systemA fixed exchange-rate system is a currency system in which governments try to keep the value of their currencies constant against one another....
- Currency unionCurrency unionA currency union is where two or more states share the same currency, though without there necessarily having any further integration such as an Economic and Monetary Union, which has in addition a customs union and a single market.There are three types of currency unions:#Informal - unilateral...
- Black WednesdayBlack WednesdayIn politics and economics, Black Wednesday refers to the events of 16 September 1992 when the British Conservative government was forced to withdraw the pound sterling from the European Exchange Rate Mechanism after they were unable to keep it above its agreed lower limit...
- Capital controlCapital controlCapital controls are measures such as transaction taxes and other limits or outright prohibitions, which a nation's government can use to regulate the flows into and out of the country's capital account....
- ConvertibilityConvertibilityConvertibility is the quality that allows money or other financial instruments to be converted into other liquid stores of value. Convertibility is an important factor in international trade, where instruments valued in different currencies must be exchanged....
- Currency boardCurrency boardA currency board is a monetary authority which is required to maintain a fixed exchange rate with a foreign currency. This policy objective requires the conventional objectives of a central bank to be subordinated to the exchange rate target....
- Impossible trinityImpossible trinityThe Impossible Trinity is a trilemma in international economics suggesting it is impossible to have all three of the following at the same time:...
- Linked exchange rateLinked exchange rateA linked exchange rate system is a type of exchange rate regime to link the exchange rate of a currency to another. It is the exchange rate system implemented in Hong Kong to stabilise the exchange rate between the Hong Kong dollar and the United States dollar...
- Speculative attackSpeculative attackA speculative attack is a term used by economists to denote a precipitous acquisition of something by previously inactive speculators. The first model of a speculative attack was contained in a 1975 discussion paper on the gold market by Stephen Salant and Dale Henderson at the Federal Reserve Board...
- Swan diagramSwan diagramthumb|The Swan diagramIn economics, a Swan diagram, also known as the Australian model , represents the situation of a country with a currency peg. The concept was developed by Trevor Swan in 1955.Two lines represent a country's respective internal thumb|The Swan diagramIn economics, a Swan...
- Managed float regimeManaged float regimeManaged float regime is the current international financial environment in which exchange rates fluctuate from day to day, but central banks attempt to influence their countries' exchange rates by buying and selling currencies...