What the Heck is a Fixed Exchange Rate? (Unfiltered, Uncensored, and Unapologetic Version)
A Fix Rate Exchange: Definition Explained Alongside Practical Illustrations
A fixed exchange rate is a currency valuation system that ties a country's currency to the market price of another, a basket of currencies, or to the value of a commodity or a basket of commodities.
Let's Dive into Fixed Exchange Rates, Shall We?
A fixed exchange rate system is a regime implemented by a government or central bank that locks one country's official currency value to another country's currency or to the price of a valuable commodity that retains its worth. The purpose of a fixed exchange rate system is to keep a currency's value within a narrow band.
The Lowdown: Key Takeaways
- The aim of a fixed exchange rate system is to keep a currency's value constrained within a tight band.
- Fixed rates offer greater certainty for exporters and importers, and help the government keep inflation at bay, maintaining low interest rates and stimulating economy growth.
- Many industrialized nations switched to a floating exchange rate system in the 70s, although several developing economies still operate using fixed-rate systems.
Decoding Fixed Exchange Rates, Step by Step
Fixed rates give a sense of safety for exporters and importers, as well as help the government manage low inflation, leading to relatively low interest rates, boosting trade and investment. Most major industrialized nations utilize floating exchange rate systems, where the current market price on the foreign exchange market (forex) sets their currency price.
Bretton Woods Agreement: A Brief History
From the end of World War II to the early 70s, the Bretton Woods Agreement meant that the exchange rates of participating nations were pegged to the value of the U.S. dollar, which was fixed to the price of gold. When the U.S.'s postwar balance of payments surplus turned into a deficit in the 50s and 60s, the occasional exchange rate adjustments permitted under the agreement proved insufficient. In 1973, President Richard Nixon took the U.S. out of the gold standard, ushering in the era of floating rates.
The Monetary Union Beginnings
The European Exchange Rate Mechanism (ERM) was founded in 1979 as a forerunner to the monetary union and the introduction of the euro. Member nations, including Germany, France, the Netherlands, Belgium, and Italy, agreed to keep their currency rates within 2.25% of a central point. The United Kingdom joined in October 1990 at an excessively strong conversion rate and was forced to withdraw two years later. The original members of the euro converted from their home currencies at their then-current ERM central rate on January 1, 1999. The euro itself trades freely against other major currencies, while the currencies of countries hoping to join trade in a managed float known as ERM II.
Downsides of Fixed Exchange Rates
Developing economies often use a fixed-rate system to restrain speculation and establish a stable system. A stable system allows importers, exporters, and investors to plan without worrying about currency swings.
However, a fixed-rate system hinders a central bank's ability to adjust interest rates as necessary for economic growth. A fixed-rate system also prevents market adjustments when a currency becomes over- or undervalued. Effective management of a fixed-rate system requires a substantial pool of reserves to support the currency when it's under attack.
An unrealistic official exchange rate can also lead to the development of an unofficial parallel, or dual, exchange rate. A significant gap between official and unofficial rates can divert hard currency away from the central bank, potentially causing forex shortages and periodic large devaluations. These can be more disruptive to an economy than the periodic adjustment of a floating exchange rate regime.
Examples of Fixed Exchange Rates in Action
In 2018, according to BBC News, Iran set a fixed exchange rate of 42,000 rials to the dollar, after losing 8% against the dollar in a single day. The government decided to eliminate the disparity between the rate traders used, 60,000 rials, and the official rate, which was 37,000 at the time.
A Fixed Exchange Rate vs. a Floating Exchange Rate: What's the Difference?
With a fixed exchange rate, a government or central bank establishes a fixed rate for the currency, which remains stable. Alternatively, market forces determine the exchange rate for a currency based on its supply and demand.
Is the U.S. Dollar a Floating Currency?
You betcha! The U.S. Dollar is a floating currency, meaning its exchange rate is determined by its supply and demand in relation to other currencies.
- In the implementation of a fixed exchange rate system, a government or central bank maintains the currency's value by tying it to another country's currency or a valuable commodity, providing greater certainty for investors and exporters, and aiding in the management of inflation.
- As opposed to a fixed exchange rate, a floating exchange rate system, such as the one used by the United States, allows market forces to determine the currency's value based on supply and demand, providing more flexibility for interest rate adjustments and economic growth.
