Fixed Exchange Rate System

A fixed (or pegged) exchange rate system is one where governments or central banks set official exchange rates and defend the set rates through foreign exchange market intervention and monetary polices. Under this system, the currency is pegged to another currency (or basket of currencies) and the central bank promises to exchange currency at a specified rate against the other currency. Each central bank actively buys or sells its currency in foreign exchange market whenever its exchange rate threatens to deviate from its stated par value by more than an agreed-upon percentage.

For example, India pegs its Rupee to the U.S. dollar at a rate of 45 rupee per dollar. The Reserve Bank of India(RBI) must always be willing to buy rupee with dollars or to buy dollars with rupee in any amount at the fixed rate of 45 rupee per dollar. Otherwise, there could be excess supply of or demand for rupee, and its value would depreciate or appreciate to restore equilibrium. For example, if there were excess demand for rupee, the rupee would become more valuable relative to the dollar, and the number of rupee to buy a dollar would decrease, implying an appreciation of the rupee. In order to prevent such a move in the exchange rate, The Reserve Bank of India intervenes in foreign exchange markets to meet the excess demand by increasing the supply of rupee through buying dollars. Thus, while the exchange rate does not move, the dollar reserves of the central bank do change. Were these reserves to run out, The Reserve Bank of India(RBI) would indeed have little choice but to float the rupee.

In order to avoid the need to respond to all movements in the supply and demand for currency, a country may fix its currency within a band to allow some fluctuation in value. For example, from 1979 to 1998, a number of countries participated in the European Monetary System. Under this system, countries exchange rates were fixed but allowed to fluctuate up or down by as much as 6% (widened to 15% in 1993) relative to an assigned par value. The bands allowed countries some latitude with choosing monetary policies and also were intended to reduce the risks of speculative attacks. In 2004, only one large economy-Denmark-used this type of exchange rate regime.

The Gold Standard Exchange Rate System, the Bretton Woods System, and the European Monetary System (EMS) are historical examples of fixed exchange rate regimes, although they differ in specific aspects.

The key features of the fixed exchange rate system are:

  • Domestic currency is pegged to an anchor currency.
  • Prices and interest rates have to be in line with the anchor currency, which ensures monetary discipline.
  • Central bank has responsibility to defend exchange rate by foreign exchange market intervention.
  • Central bank has to maintain adequate international reserves to intervene in the foreign exchange market.

The various forms of fixed exchange rate system are as follows:

  • Conventional Fixed Peg Arrangement: In this system, a country pegs its currency at a fixed rate to a major currency or a basket of currencies with a band of variation not exceeding plus or minus 1% around the central rate.
  • Currency Board System: Under the currency board system a country pegs its currency with another major currency and fixes the rate of its domestic currency in terms of that foreign currency. Its exchange rate in terms of other currencies depends on the exchange rates between the domestic currency and the currency to which it is pegged. The monetary policies and the economic variables are kept in line with that of the reference country by the central monetary authority, called the currency board. The currency board maintains reserves of the anchor currency up to 100% or more of the domestic currency in circulation. This means that a unit of domestic currency cannot be introduced into the economy without an additional unit of foreign exchange reserves being obtained first. Currency board commits to convert its domestic currency on demand into the anchor foreign currency to an unlimited extent, at the fixed exchange rate. Thus, a currency board has three important components: the establishment of a fixed exchange rate, the requirement that central bank reserves cover 100% of the monetary base at that exchange rate, and the obligation that the central bank meets all demand for anchor currency. As such, a currency board imposes discipline on governments by prohibiting increases in money supply beyond the level of reserves. It also prohibits the central bank from extending credit to commercial banks and rules out a role as lender of last resort. Clearly, a currency board does not make a country immune to speculative attack. But it provides a more credible guarantee of a country’s commitment to a fixed exchange rate by limiting the ability of traders to launch speculative attacks against the local currency.
  • Crawling Pegs: Another variation on a fixed exchange rate system is the crawling peg or crawling band. Under a crawling peg, the central bank adjusts the value of its currency periodically in small amounts at a fixed, pre-announced rate or in response to changes in specific indicators.
  • Target Zone Arrangement: A group of countries agree to maintain the exchange rate between the currencies within the certain band around fixed central exchange rates. The system is called the target zone arrangement in which convergence of economic policies of the participating countries are a prerequisite for this system.
  • Monetary Union: Under this system the member nations of monetary unions agree to use a common currency, instead of their individual currencies. This wipes out the fluctuations of exchange rates and the attendant inefficiencies completely. A common central bank of member countries is set up, which has the sole authority to issue currency and to determine the monetary policy of the group as a whole. The central bank has the power to alter economic variables of member nations to maintain the same inflation rate in all the member nations. European monetary union is an example of a monetary union. It has its own common currency (Euro) and has a common central bank.

The ability of the central bank to defend its currency under a fixed exchange rate system is limited by its stock of foreign exchange reserves and by its ability to raise interest rates. If there is persistent excess demand for anchor currency, the central bank must sell anchor currency, and its reserves therefore fall. If the central bank’s reserves run low and it is unable to secure financing from private markets, it may have to devalue the exchange rate. Likewise, countries may be unable to increase interest rates to the levels necessary to defend their national currency, maybe because unemployment is too high already or the public debt is becoming unsustainable.

Advantages of Fixed Exchange Rate System

  • It leads to orderly foreign exchange market.
  • Fixed exchange rates require countries to adopt restrictive monetary and fiscal policies that foster an anti-inflationary environment. Thus it ensures monetary and fiscal discipline on the domestic economy.
  • Fixed exchange rate regimes promote institutional credibility by signaling monetary discipline.
  • It promotes international trade by providing stability in international prices and reducing the cost of trading.

Disadvantages of Fixed Exchange Rate System

  • Loss of monetary independence: Central bank cannot use money supply as a tool to stimulate the economy. The central bank would also be unable to respond to unemployment through lowering the interest rate to stimulate investment because of concerns about the effect on the exchange rate.
  • Burden to keep adequate reserves.
  • It is subject to destabilizing speculative attacks. Example, speculative attacks on British pound in 1992, on east Asian currencies in 1997 and Argentinean peso in 2001.
  • Danger of sudden collapse of system and financial and economic instability.
  • Fixed rates may be maintained at rates that are inconsistent with economic fundamentals, thereby exacerbating periods of recession.

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