The fixed exchange rate system, also known as a pegged exchange rate system, is a monetary regime in which the value of a country’s currency is tied to another country’s currency, a basket of currencies, or another measurable unit, such as gold. The fixed exchange rate is usually maintained within a narrow band through government intervention in currency markets.

What Is a Fixed Exchange Rate?

A fixed exchange rate, sometimes called a pegged exchange rate, is a type of exchange rate regime in which a currency’s value is matched to the value of another single currency or to a basket of other currencies. A fixed exchange rate is usually maintained by the government through active buying and selling of currency in the foreign exchange market to stabilize the value of its own currency.

Under a fixed exchange rate system, the central bank first announces a fixed price for its currency and then buys and sells that currency as needed to maintain that price. The fixed price, or peg, serves as a nominal anchor for the domestic currency and provides a stable value against other foreign currencies.

Some key features of a fixed exchange rate system are:

  • The currency’s value is pegged to another currency, like the U.S. dollar or euro. This is called the anchor currency.
  • The exchange rate is maintained within a narrow margin around the central fixed rate. Minor fluctuations may occur.
  • The country’s central bank must continually intervene in the forex market to maintain the pegged rate. This requires having sufficient foreign exchange reserves.
  • Monetary policy becomes focused on external stability rather than domestic inflation and employment goals.
  • Interest rates generally move with the anchor nation to defend the fixed rate. Independent monetary policy is limited.
  • Devaluation or revaluation of the fixed rate is possible, but less frequent.

Essentially, the currency’s value under a fixed exchange rate system depends on the success or failure of the anchor nation’s currency and monetary policy.

Why Have a Fixed Exchange Rate?

There are several key reasons why a country may want to adopt a fixed exchange rate system:

Price Stability

A fixed exchange rate helps minimize exchange rate fluctuations and provides price stability for international transactions. This reduces uncertainty and risk for imports and exports. Businesses can more easily engage in international trade with predictable currency values.

Reduces Speculation

Pegging the domestic currency to a stable foreign anchor currency helps reduce destabilizing currency speculation. With less volatility, there is less room for speculators to attack the currency’s value.

Macroeconomic Discipline

Maintaining the peg forces fiscal and monetary discipline on the domestic economy. The central bank cannot print money or lower interest rates without undermining the fixed rate. Governments must control spending and borrowing to align with the anchor nation.

Simplicity & Predictability

A single fixed rate is simple for firms and individuals to understand compared to floating rates that constantly fluctuate. The predictable exchange rate allows easier financial planning and budgeting.

Credibility & Confidence

Pegging to a stable major currency imports credibility and inspires confidence in the domestic currency, both domestically and internationally. This boosts investment and borrowing.

Controlled Import Prices

Fixing the exchange rate helps control import prices, especially for essential commodities like oil that are priced globally in U.S. dollars or euros. Local currency prices for imports are more stable.

Disadvantages of a Fixed Exchange Rate

While fixed exchange rates have some benefits, there are also notable downsides to consider:

Loss of Independent Monetary Policy

The ability to set an independent monetary policy based on domestic economic conditions is lost under a fixed rate. Interest rates generally must follow the anchor nation’s rates rather than respond to internal inflation or unemployment.

Susceptible to Speculative Attacks

Since the actual market demand for the currency may differ from the pegged rate, the currency can become vulnerable to intense speculation that pushes the value outside of the maintained range. This may force a devaluation.

Misalignments & Adjustment Pressure

If the market rate diverges too far from the pegged rate over time, the currency can become overvalued or undervalued. Significant misalignments require painful macroeconomic adjustments to realign the currency’s real value back to equilibrium.

Importing Economic Instability

Pegging to another currency imports the economic instability and business cycles of that anchor nation. For example, higher U.S. interest rates may inadvertently slow down an emerging economy with its currency tied to the dollar.

Reduced Seigniorage Revenue

Central banks earn income from issuing currency, known as seigniorage revenue. This is reduced under a fixed exchange rate since the central bank holds foreign reserves rather than domestic currency assets.

Higher Risk of Crisis

Maintaining the peg drains foreign exchange reserves over time. If reserves run too low, a major panic by forex traders can force a painful currency crisis and collapse of the fixed rate system.

Historical Examples of Fixed Exchange Rates

Fixed exchange rates have been used at various times over the centuries, notably during the gold standard of the late 1800s up until World War I. More recently, the Bretton Woods system instituted pegged but adjustable exchange rates from 1945 to the early 1970s.

Some current examples of economies using fixed exchange rate regimes include:

  • Hong Kong dollar pegged to the U.S. dollar.
  • Saudi riyal pegged to the U.S. dollar.
  • Denmark krone pegged to the euro currency.
  • Azerbaijan manat pegged to the euro.
  • China yuan pegged to a basket of major currencies.
  • Lebanon pound pegged to the U.S. dollar.

Historically, fixed exchange rates have provided long periods of currency stability punctuated by occasional currency crises and forced devaluations when governments can no longer maintain the peg.

How Does a Fixed Exchange Rate System Work?

There are several key components to how a fixed exchange rate system functions in practice:

Official Exchange Rate Declaration

The first step is for the country’s central bank or currency issuing monetary authority to declare the fixed price or exchange rate for its own currency against a major anchor currency.

For example, the Hong Kong Monetary Authority sets a rate of 7.80 Hong Kong dollars to 1 U.S. dollar. This serves as the official fixed exchange rate that will be maintained.

Forex Market Intervention

Once the official rate is set, the central bank then must actively intervene in the forex market whenever the market exchange rate diverges from the declared fixed rate.

To maintain the rate, the central bank buys up domestic currency when the currency weakens and threatens to drop below the set rate. And it sells domestic currency when the currency strengthens and exceeds the upper boundary of the fixed rate range.

Sufficient foreign exchange reserves are needed to fund the central bank’s market operations.

Adjust Domestic Money Supply

Along with market intervention, the central bank also adjusts the domestic money supply to maintain the fixed exchange rate target.

Expanding the money supply puts downward pressure on the currency’s value, while contracting the money supply bolsters demand for the currency and supports its pegged price.

Modify Domestic Interest Rates

Changes to domestic interest rates may also be needed at times to maintain the equilibrium of the fixed rate.

Higher interest rates make deposits and investments in that currency more attractive for global investors and increase demand for the currency. This supports the currency peg.

Fiscal Policy Alignment

Fiscal policy also plays a role in aligning the domestic economy with the anchor nation’s conditions under a fixed rate.

Government spending and tax policies must be coordinated to avoid large deficits or debts that could jeopardize the currency peg through devaluation expectations.

Realignments & Devaluations

If economic fundamentals diverge too much under the fixed rate, authorities may conduct a realignment to reset the exchange rate parity or a devaluation to lower the currency’s pegged value against the anchor currency.

Types of Fixed Exchange Rate Systems

While some fixed exchange rates are simply pegged to a single major currency like the U.S. dollar, there are other variations of fixed rate regimes:

Peg to a Currency Basket

Rather than tie its value to just one major currency, a country can peg to a basket of several major currencies.

The central bank sets a benchmark for the value of its currency against this basket. This provides more stability by diversifying across several anchors rather than relying on just one.

For example, China has pegged the yuan to a basket with heavy weighting given to the euro, yen, won, and dollar.

Crawling Peg

With a crawling peg, the fixed rate itself adjusts at a set pace over time. The minor adjustments to the peg can help gradually keep the currency aligned with shifting macroeconomic conditions.

For example, the peg may crawl downwards at 0.5% per month to allow for higher domestic inflation than the anchor country. This prevents the currency from becoming too overvalued over time.

Peg with Horizontal Bands

Rather than a single fixed rate, the target is set as a range. The exchange rate is allowed to fluctuate within horizontal bands on either side of the central parity rate.

This mechanism provides more flexibility for market-based adjustments while still limiting major swings beyond the bands. For example, Denmark allows fluctuations of 2.25% around its central rate pegged to the euro.

The Role of Currency Reserves

Sufficient currency reserves are vital for any fixed exchange rate regime. Central banks use these reserves of foreign currencies and gold to intervene in forex markets.

When the domestic currency weakens towards the lower end of its maintained band, the central bank can buy up domestic currency in exchange for foreign reserves. This props up demand and supports the currency’s pegged value.

Conversely, if the domestic currency strengthens too much, the bank sells domestic currency from its reserves to increase supply. This keeps the currency from exceeding its ceiling rate.

Forex reserves provide the installed firepower to directly influence the currency’s value. As reserves dwindle, speculation against the fixed rate can overwhelm the central bank’s capacity to intervene. This often forces abandonment of the peg.

Adjustments Within a Fixed Exchange Rate System

Realignments

If economic conditions change, a central bank may conduct a realignment to reset the fixed parity rate. This involves discretely devaluing or revaluing the fixed rate to better reflect the currency’s true market value against the anchor.

For example, if high domestic inflation has made a currency overvalued relative to fundamentals, authorities can realign to a lower exchange rate that is more viable.

Realignments are less disruptive than abandoning the peg entirely. But frequent realignments undermine the credibility of the fixed system.

Widened Band Rates

Rather than reset the central rate, a country can maintain the same midpoint peg but widen the permissible bands around it.

This allows more natural market adjustment and relieves some pressure on the currency while still providing exchange rate structure. For example, the Danish krone’s band was expanded from +/- 0.5% to +/- 2.25% against the euro peg to accommodate market forces.

Changes in Anchor Currency

Countries may shift the anchor currency they fix to over time. For example, Vietnam changed from pegging its dong to the U.S. dollar to pegging to a basket of currencies to better reflect its trading partners.

Shifting anchors allows a currency peg to realign if the original anchor currency becomes unsuitable.

The Role of Interest Rates Under a Fixed Regime

To maintain a credible fixed peg, interest rate policy comes into play along with forex market intervention and money supply adjustments.

If the pegged currency suddenly weakens, threatening to fall below its band, the central bank can raise domestic interest rates. Higher rates make deposits and fixed income investments in that currency more attractive relative to foreign alternatives.

This stimulates demand for the domestic currency, supporting its pegged price. The central bank often coordinates interest rate moves with the anchor currency central bank.

Conversely, if the domestic currency exceeds its ceiling rate, interest rates can be cut to make the currency less attractive relative to anchor currencies. This encourages selling of the domestic currency, bringing its value back down towards the pegged rate.

Since interest rates must defend the fixed exchange rate rather than respond to growth and inflation, using interest rates limits flexibility in monetary policy.

The Role of Inflation Under a Fixed Regime

Inflation dynamics are also important for exchange rate regimes. Countries with higher inflation than their fixed rate anchors will face appreciation pressure on their currencies. This can push the currency’s value above the permissible ceiling.

To counteract excessive inflation under a peg, central banks can tighten monetary policy, even if it means hampering domestic growth and employment. Tighter policy restrains inflation and makes the pegged rate viable.

Likewise, if the anchor country’s inflation rises, its currency is likely to depreciate. This puts downward pressure on the pegged domestic currency too. The central bank may need to loosen monetary policy to allow controlled depreciation under the peg to stay in sync with the anchor’s declining value.

Keeping inflation aligned is crucial to prevent misalignments between market and pegged rates.

Why Countries Abandon Fixed Exchange Rates

Despite their potential benefits, fixed exchange rates often break down due to political constraints and shifting macroeconomic realities:

Unsustainable Currency Misalignments

As economic conditions diverge between the domestic economy and the anchor nation, the fixed rate can become highly misaligned with the true equilibrium value. For example, rapid productivity growth may make a currency greatly undervalued relative to fundamentals at the pegged rate. This creates pressure to float the currency to seek its true market rate.

Speculative Attacks

When pegs become visibly unsustainable, forex traders will attack the rate through massive speculative selling leading to a rapid depletion of reserves. This occurred in 1992 when currency trader George Soros broke the Bank of England peg.

Insufficient Currency Reserves

As defending the fixed peg is extremely reserve-intensive over time, central banks often deplete their finite currency reserves. This leaves them unable to counter further waves of speculation against an increasingly misaligned rate.

Political Constraints

Domestic political pressure may prevent the fiscal austerity, higher interest rates, and economic contraction required to realign fundamentals back to the pegged rate. Populations unwilling to accept reduced living standards force governments’ hands.

Negative Economic Effects

The negative economic effects of maintaining the peg also spark public discontent and make clinging to the fixed rate politically infeasible. For example, higher unemployment from defending an overvalued rate can spur regime change.

Floating Exchange Rates vs. Fixed Exchange Rates

The choice between floating and fixed exchange rates entails tradeoffs:

Floating exchange rates:

  • Adjust naturally based on market forces of supply and demand
  • Allow independent monetary policy based on domestic economic conditions
  • Absorb economic shocks efficiently through exchange rate movements rather than recessions
  • Subject to much greater short-term volatility

Fixed exchange rates:

  • Provide exchange rate certainty and stability
  • Require subordinating monetary policy to maintain the peg
  • Import credibility and discipline of the anchor currency nation
  • Vulnerable to speculative attacks and currency crises
  • Allow currency misalignments to grow over time

There is no consensus on which regime is universally optimal. In practice, most advanced economies float their currencies today, while many emerging markets use various fixed exchange rate structures.

When Is a Fixed Exchange Rate Optimal?

While not universally ideal, certain conditions make adopting a fixed exchange rate more advantageous:

  • Strong extensive trade and investment links with the anchor currency country
  • High general price sensitivity and pass-through of exchange rates into local inflation
  • Underdeveloped capital markets and lack of policy credibility, where the discipline of the fixed rate is beneficial
  • Political commitment to maintaining the parity rate indefinitely
  • Sufficient currency reserves and fiscal conditions to defend against speculative attacks
  • Willingness to subordinate domestic policy goals to the external peg

Historical periods of global political stability and cooperation, such as the Bretton Woods era, have also provided favorable backdrops for fixed rate regimes.

The Breakdown of Past Global Fixed Rate Systems

In the modern economy, fixed exchange rate systems have generally arisen during times of global coordination and stability but later broken down due to diverging national interests:

Gold Standard System (1870s – 1914)

The classical gold standard provided for currencies pegged to a set amount of gold, with central banks standing ready to buy and sell gold at the fixed price. This provided exchange rate stability but collapsed under the economic pressures of World War I and the need to finance massive war expenditures.

Bretton Woods System (1945 – 1971)

Under Bretton Woods, currencies were nominally pegged to the U.S. dollar, while the dollar itself was convertible to gold at $35 per ounce held by the Federal Reserve. This allowed minor currency fluctuations within 1% bands. However, the system dissolved due to dollar overvaluation against gold and other macroeconomic divergences. President Nixon ended dollar-gold convertibility in 1971.

European Monetary System (1979 – 1999)

The European Monetary System was a pegged rate mechanism that preceded formal eurozone monetary union. Member countries pegged their currencies to each other within a trading range of +/- 2.25% and later +/- 15% around bilateral central rates. Speculative attacks in the 1990s pushed the UK and Italy to drop out, while the euro was later adopted by members in 1999.

Challenges of Transitioning from Fixed to Floating Rates

The breakdown of fixed exchange rates has often proven challenging for countries transitioning to freely floating currencies:

  • Great uncertainty and volatility typically surround a new float, complicating trade and investment.
  • Lacking credibility and clout, currencies can experience sharp depreciations as markets test the central bank’s limits.
  • Weak financial supervision, regulation, and market infrastructure can exacerbate volatility episodes.
  • Monetary policy may lack independence and effectiveness for stabilizing the currency’s value under a pure float.
  • Inflationary psychology takes time to adjust as previous currency values shape price-setting habits.
  • Fiscal discipline and transparency become more crucial as loose policy directly weakens the exchange rate.
  • Current account adjustments are forced to occur through exchange rates rather than peg adjustments.

Mastering a floating rate after having long relied on a fixed peg presents policy learning curves for central banks. But benefits accrue over time as monetary independence allows responding to local economic needs.

The Future of Fixed Exchange Rates

While fixed rates have grown less common, they still play important roles for some emerging markets and economies closely tied to major anchors. Several directions could shape the future evolution of fixed exchange rate regimes:

  • More limited flexible regimes like crawling pegs and managed floats rather than strict pegs. This allows gradual exchange rate adjustments while avoiding traumatic currency crises.
  • Pegging to currency baskets rather than single currencies to diversify risk. Weights can shift over time to manage changing trade and investment flows.
  • Coordinated pegs between economic or political partner nations, such as the GCC’s continued dollar peg for long-term stability.
  • Fluctuation bands expanded to rates like +/- 10% to accommodate normal market swings under the management of currency boards.
  • Development of robust offshore currency markets and financial instruments to hedge risk for key trading partners, reducing the need for fully fixed rates.
  • Digitization making major fiat pegs obsolete as blockchain-based stabilized coins take over emerging economy payment systems and reduce reliance on USD, EUR, etc.
  • Geopolitical power shifts decreasing the relative importance of particular major currency anchors, opening room for greater exchange rate flexibility.

Fixed exchange rates retain important monetary policy roles but require prudent updating as economic conditions evolve. Careful management of pegged regimes can limit currency volatility while retaining national competitiveness.

Conclusion

In summary, fixed exchange rate systems allow central banks to pin their currencies’ values to other major currencies or baskets. Maintaining the peg necessitates forex market intervention, interest rate coordination, and inflation control to prevent currency misalignments. Fixed rates provide stability but reduce monetary independence. While pegs have repeatedly broken down over history, updated variations continue providing discipline for select economies without severely sacrificing policy flexibility. Carefully evolving fixed exchange rate regimes into the future remains vital for global trade and growth.