What Is a Fixed Exchange Rate?

What Is a Fixed Exchange Rate?

Let me explain what a fixed exchange rate really is. It's a system where a government or central bank ties your country's currency value directly to another country's currency or to the price of a commodity that holds value, like gold. The goal here is straightforward: keep that currency's value stable within a tight range.

Understanding Fixed Exchange Rates

You need to know that fixed exchange rates bring a high level of price stability. They provide certainty for exporters and importers, and they help governments maintain low inflation. Over time, this keeps interest rates down and boosts trade and investment.

Most major industrialized nations now use floating exchange rate systems, where the forex market determines the currency price. This shift happened for them in the early 1970s, but some developing economies still stick with fixed rates.

Bretton Woods Agreement

From the end of World War II until the early 1970s, the Bretton Woods Agreement pegged participating nations' exchange rates to the U.S. dollar, which was itself fixed to gold.

When the U.S. postwar surplus turned into a deficit in the 1950s and 1960s, the allowed adjustments under the agreement weren't enough. In 1973, President Nixon took the U.S. off the gold standard, starting the floating rate era.

The Beginnings of the Monetary Union

The European Exchange Rate Mechanism (ERM) started in 1979 as a step toward monetary union and the euro. Countries like Germany, France, the Netherlands, Belgium, and Italy agreed to keep their currencies within 2.25% of a central point.

The UK joined in 1990 at a rate that was too strong and had to pull out two years later. The original euro members converted at their ERM central rates on January 1, 1999. The euro trades freely against other majors, while aspiring joiners use a managed float called ERM II.

Disadvantages of Fixed Exchange Rates

Developing economies often choose fixed rates to curb speculation and create stability. This lets importers, exporters, and investors plan without currency fluctuation worries.

But here's the downside: it restricts a central bank's ability to tweak interest rates for growth. It also blocks market corrections if a currency gets over- or undervalued. Managing it effectively demands large reserves to defend the currency under pressure.

An unrealistic official rate can spawn a parallel unofficial rate. A big gap between them pulls hard currency from the central bank, causing shortages and big devaluations. These disruptions can hit an economy harder than the steady adjustments in a floating system.

What Is a Real-World Example of a Fixed Exchange Rate?

Take Iran in 2018, as reported by BBC News. They fixed their exchange rate at 42,000 rials to the dollar after an 8% drop in one day. The government aimed to close the gap between the traders' rate of 60,000 rials and the official 37,000.

What Is the Difference Between a Fixed Exchange Rate and a Floating Exchange Rate?

In a fixed system, the government or central bank sets and maintains a stable rate. In a floating one, market supply and demand dictate the rate.

Is the U.S. Dollar a Floating Currency?

Yes, the U.S. dollar floats, with its rate determined by supply and demand against other currencies.

The Bottom Line

Countries might fix their exchange rate to another currency or asset like gold to stabilize value. But fixed rates come with limitations for the economy, which is why most developed nations prefer floating rates.