{"id":264921,"date":"2024-07-18T10:46:19","date_gmt":"2024-07-18T10:46:19","guid":{"rendered":"https:\/\/imarticus.org\/blog\/?p=264921"},"modified":"2024-09-25T11:54:26","modified_gmt":"2024-09-25T11:54:26","slug":"fixed-exchange-rate-system","status":"publish","type":"post","link":"https:\/\/imarticus.org\/blog\/fixed-exchange-rate-system\/","title":{"rendered":"What is the Fixed Exchange Rate System? Why is it Important?"},"content":{"rendered":"
Let us assume that we are an Indian company that imports exotic fruits from Thailand. We need to pay Thai Baht for our purchases, but our income is in Indian Rupees or INR. This is where exchange rates come in. They act as the conversion bridges between different currencies, allowing international trade to flow smoothly.<\/span><\/p>\n Exchange rates constantly fluctuate based on supply and demand for each currency. However, some countries choose to implement a <\/span>fixed exchange rate system<\/span>. This means their currency's value is pegged to another stable currency, a basket of currencies, or even a commodity such as gold. In contrast, most countries today operate under a floating exchange rate system, where several key market forces determine the currency's value.<\/span><\/p>\n Let us dive in and learn all about the <\/span>fixed exchange rate system<\/span>.<\/span><\/p>\n The <\/span>fixed exchange rate system<\/span> functions through the central bank's active role in managing the exchange rate between the domestic currency and its chosen peg (another currency, basket of currencies, or commodity).<\/span><\/p>\n The central bank selects a reference point for the domestic currency. This could be a single strong currency like the US Dollar or a basket of currencies representing important trading partners. The central bank fundamentally acts like a stabiliser, ensuring the exchange rate stays balanced at the predetermined level. They achieve this through two primary tools:<\/span><\/p>\n Now that we have covered \u201c<\/span>what is fixed exchange rate<\/span>\u201d, let us find out how the fixed exchange rates truly work. A <\/span>fixed exchange rate system<\/span> functions by pegging the value of a domestic currency to another currency (or a basket of currencies) at a predetermined exchange rate. This peg acts as a fixed point representing the desired balance between the two currencies. The central bank plays a critical role in maintaining this balance. Here is how they achieve it:<\/span><\/p>\n The central bank acts as the person in the middle, constantly adjusting the weights on the seesaw. When there is high demand for foreign currency (causing the domestic currency to weaken), the central bank sells foreign currency from its reserves and buys back its own currency. This injects domestic currency into the market, artificially raising its value and pushing it back towards the peg (restoring balance on the seesaw). Conversely, if the domestic currency becomes too strong (appreciates), the central bank can buy foreign currency and sell its own, weakening the domestic currency.<\/span><\/p>\n In some cases, countries might establish a narrow band around the fixed rate. This allows for slight fluctuations within the band due to market forces, but the central bank intervenes more aggressively when the rate strays too far outside the band (we will cover this in more detail in the later sections).<\/span><\/p>\n The <\/span>fixed exchange rate system<\/span> offers several advantages, particularly for countries prioritising stability and predictability in their economies. Here's a breakdown of some key benefits:<\/span><\/p>\n Businesses engaged in international trade thrive on knowing the exact costs involved. A <\/span>fixed exchange rate<\/span> eliminates the uncertainty associated with fluctuating currency values. Companies can confidently plan their imports and exports without worrying about sudden shifts in exchange rates that could erode their profits. This predictability fosters a more stable business environment and encourages international trade.<\/span><\/p>\n Businesses and investors appreciate the reduced volatility associated with fixed exchange rates. Budgeting and long-term planning become more manageable when currency fluctuations are minimised. This fosters a more stable financial environment for both domestic and international actors.<\/span><\/p>\n When exchange rates constantly fluctuate, businesses often need to hedge their bets by entering into complex financial contracts to mitigate potential losses. A <\/span>fixed exchange rate system<\/span> eliminates this need, leading to lower transaction costs for businesses involved in international trade.<\/span><\/p>\n Investors generally prefer to put their money in stable and predictable economies. A <\/span>fixed exchange rate system<\/span> can signal such stability, potentially attracting foreign direct investment. This influx of capital can boost economic growth and development.<\/span><\/p>\n Pegging the domestic currency to a stable currency with a low inflation rate can indirectly help control inflation in the domestic economy. We will explore this concept in more detail in the later sections of this article.<\/span><\/p>\n While offering stability, <\/span>fixed exchange rate<\/span> systems also come with significant challenges. Here is a closer look at some of the potential drawbacks:<\/span><\/p>\n One of the biggest drawbacks is the limitation on a central bank's ability to conduct independent monetary policy. In a <\/span>fixed exchange rate system<\/span>, the central bank's primary focus becomes maintaining the peg. This can restrict their ability to use interest rates as a tool to manage domestic economic issues.<\/span><\/p>\n Example:<\/b> Let us take a country with a f<\/span>ixed exchange rate<\/span> experiencing high unemployment as an example. Traditionally, the central bank could lower interest rates to stimulate borrowing and investment, potentially leading to job creation. However, in a <\/span>fixed exchange rate system<\/span>, lowering interest rates could make the domestic currency less attractive compared to the pegged currency. This could lead to investors pulling their money out, weakening the domestic currency and putting pressure on the peg. To maintain the peg, the central bank might be forced to keep interest rates high, even if it hinders efforts to address domestic unemployment.<\/span><\/p>\n Maintaining a <\/span>fixed exchange rate<\/span> can be a costly endeavour. When there is strong demand for foreign currency (putting downward pressure on the domestic currency), the central bank needs to sell foreign currency from its reserves and buy its own currency to maintain the peg. This depletes their foreign exchange reserves. Additionally, if the central bank needs to raise interest rates to defend the peg (as in the previous example), it can discourage foreign investment, further straining reserves.<\/span><\/p>\n Fixed exchange rates can make it difficult for economies to adapt to external shocks. For instance, a sudden surge in global oil prices could put pressure on a country's current account if it relies heavily on oil imports. In a floating exchange rate system, the currency would likely depreciate, making exports cheaper and imports more expensive, helping to restore balance. However, with a fixed exchange rate, such an adjustment wouldn't be possible, potentially hindering the economy's ability to adapt to the external shock.<\/span><\/p>\n Speculative attacks can pose a serious threat to fixed exchange rate systems. If investors lose confidence in a country's ability to maintain the peg, they might start selling the domestic currency in large quantities, anticipating a devaluation. This creates a self-fulfilling prophecy as the increased selling pressure weakens the currency further. If the central bank doesn't have sufficient reserves or the firepower to raise interest rates enough to defend the peg, it might be forced to devalue the currency.<\/span><\/p>\n Historical Example: <\/b>The 1997 Asian Financial Crisis offers a stark example of a currency crisis in a <\/span>fixed exchange rate system<\/span>. Several Southeast Asian countries with pegged currencies were hit by speculative attacks as investors lost confidence in their ability to maintain the peg. The central banks' reserves were depleted, and they were eventually forced to devalue their currencies, leading to significant economic turmoil.<\/span><\/p>\n The Gold Standard was a historical example of a <\/span>fixed exchange rate system<\/span> that dominated the late 19th and early 20th centuries. Under this system, the value of a country's currency was directly linked to a specific amount of gold. This created a sense of stability and predictability in international trade.<\/span><\/p>\n Advantages:<\/b><\/p>\n Limitations:<\/b><\/p>\n The classic <\/span>fixed exchange rate system<\/span> has evolved to include variations that offer some flexibility:<\/span><\/p>\n Economists continue to debate the viability of fixed exchange rates in the globalised world. Some argue that the system has become outdated and inflexible in a world of volatile capital flows. Others believe that fixed exchange rates can still promote stability and growth, particularly for developing economies.<\/span><\/p>\n Factors that might influence future adoption include:<\/span><\/p>\n The future of fixed exchange rates remains uncertain, but understanding their history, variations, and ongoing debate will be crucial for navigating the complexities of the global financial landscape. If you want to know more, you can enrol in <\/span>solid <\/span>banking courses<\/span><\/a> such as an <\/span>investment banking programme<\/span>.<\/span><\/p>\n Fixed exchange rates have not become relics of the past. Here are some successful implementations:<\/span><\/p>\n The Asian Financial Crisis of 1997 serves as a stark reminder of the potential pitfalls of abandoning fixed exchange rates prematurely. Several Southeast Asian countries with pegged currencies faced speculative attacks from investors who doubted their ability to maintain the peg. As we discussed already in this article, central banks' reserves were depleted, and they were ultimately forced to devalue their currencies. This devaluation triggered a domino effect, leading to:<\/span><\/p>\n The Asian Financial Crisis underscores the importance of careful planning and strong fundamentals before abandoning fixed exchange rates. Countries need to have sufficient reserves and a credible commitment to economic reforms to weather potential storms.<\/span><\/p>\n The world of exchange rates can be complex, but understanding the <\/span>fixed exchange rate system<\/span> is a crucial step towards navigating this terrain. A fixed exchange rate pegs a domestic currency to another currency, a basket of currencies, or even a commodity like gold. This system offers stability and predictability for international trade and investment.\u00a0<\/span><\/p>\n However, it comes with limitations like reduced monetary policy independence and vulnerability to external shocks. Modern variations like currency boards and managed floats offer some flexibility within the fixed exchange rate framework.<\/span><\/p>\n The choice between a fixed and floating exchange rate system depends on a country's specific circumstances. Developing economies might prioritise the stability offered by fixed rates, while larger, more developed economies may opt for the flexibility of floating rates.<\/span><\/p>\n The future of fixed exchange rates remains an open debate, with factors like regional economic integration and technological advancements potentially influencing future adoption. Ultimately, understanding the benefits and drawbacks of fixed exchange rates empowers countries to make informed decisions about their currency regimes, fostering a more stable and prosperous global financial landscape.<\/span><\/p>\n If you are looking for solid <\/span>banking courses<\/span> that can take your career to the next level, you can opt for the <\/span>Certified Investment Banking Operations Professional<\/span> programme by Imarticus Learning. This is one of the most holistic investment banking courses<\/strong><\/a><\/span> out there that will teach you everything you need to know about investment banking<\/a>, global finance and other advanced financial concepts.<\/span><\/p>\nMechanics of the Fixed Exchange Rate System<\/span><\/h2>\n
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Pegging a Currency (Balancing Act by the Central Bank)<\/span><\/h2>\n
Buying and Selling Foreign Currency<\/span><\/h3>\n
Intervention Bands<\/span><\/h3>\n
Benefits of a <\/span>Fixed Exchange Rate System<\/span><\/h2>\n
Predictability for International Trade<\/span><\/h3>\n
Reduced Currency Fluctuations<\/span><\/h3>\n
Lower Transaction Costs<\/span><\/h3>\n
Attracting Foreign Investment<\/span><\/h3>\n
Controlling Inflation<\/span><\/h3>\n
Challenges of a <\/span>Fixed Exchange Rate System<\/span><\/h2>\n
Loss of Monetary Policy Independence<\/span><\/h3>\n
Defending the Peg Can Be Expensive<\/span><\/h3>\n
Limited Flexibility in Turbulent Times<\/span><\/h3>\n
Vulnerability to Currency Crises<\/span><\/h3>\n
Fixed Exchange Rates Through Time and Variation<\/span><\/h2>\n
Historical Perspective<\/span><\/h3>\n
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Modern Variations<\/span><\/h3>\n
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The Future of Fixed Rates<\/span><\/h3>\n
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\n<\/span><\/li>\nReal-World Examples: <\/span>Fixed Exchange Rate<\/span> in Action<\/span><\/h2>\n
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Challenges of Abandoning Fixed Rates<\/span><\/h3>\n
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\n<\/span><\/li>\nFixed or Float?<\/span><\/h2>\n
Wrapping Up<\/span><\/h4>\n