Fixed Exchange Rate Essay ⋆ Business Essay Examples ⋆ EssayEmpire

A fixed exchange rate is a monetary regime adopted by a nation’s government or its central bank in the context of its international trade and finance to maintain a fixed price of its currency in terms of the currency (or a basket of currencies) of its major trading partner(s). The fixed exchange rate is achieved through a nation’s intervention (buying and selling) of the designated currencies on the foreign-exchange market, a private entity. This activity by the monetary authority of a nation compensates for the disequilibria of the demand and supply between the local and foreign currencies resulting from market fluctuations and subsequently keeps the exchange rate on the desired target.

The fixed exchange regime is also referred to as a pegged exchange system, in which case a nation’s currency is pegged to a major world currency such as the U.S. dollar or euro at a particular rate. A country with a fixed exchange rate regime maintains a sufficient amount of the foreign currency that it pegs to (e.g., US$) in its foreign exchange reserves in order to keep its foreign exchange regime solvent. Suppose that China fixes its currency yuan with US$. After agreeing to purchase a number of Boeing airplanes from the United States, a large quantity of US$ is demanded (or bought) by supplying (or selling) the yuan in order for the Chinese buyer to pay Boeing. Consequently, the amount of US$ decreases while the quantity of Chinese yuan increases at the foreign exchange market. Accordingly and to counterbalance for its fixed exchange rate, the monetary authority in China will need to demand (buy or revalue) yuan from and supply (sell or devalue) US$ to the foreign exchange market. The reserved currency or value in this case could either be in the form of cash or U.S. Treasury bonds.

Countries with a fixed exchange rate regime also need to intervene when the interest rates of the two countries are at disparity. Using the same two-country example above, when the United States lowered its interest rate during the credit crisis to save the economy in 2008, Americans demanded more yuan for higher expected asset returns in China. The central bank in China will need to infuse more yuan and buy back US$ at the foreign-exchange market. The foreign exchange reserve increases when the country runs a balance of payments (BoP) surplus and decreases when BoP is in deficit under a fixed exchange rate regime.

In more recent years, a modified version was developed within the fixed exchange rate regime adopting a narrow band around the target rate for small adjustments. Under the European Exchange Rate Mechanism, member nations have a fixed exchange rate to the European Currency Unit (ECU). The central bank of a nation may intervene to stabilize its currency if it moves out of the 2.5 percent range, plus or minus, with the ECU.

A fixed exchange rate regime provides a higher level of certainty and control for traders in goods, services, and currencies. Because it is shielded from day-to-day fluctuations in the foreign exchange market, international trade and investment becomes less volatile and incurs limited speculation. Under a well-managed fixed exchange rate regime, where there are absences of expectations in devaluation of the local currency, inflation is contained and investments in domestic assets are protected.

Nonetheless, the fixed exchange rate regime may cause a BoP crisis when there is excessive demand in the foreign exchange reserve that ultimately brings foreign currency down to zero and when the system becomes depleted. The cause of the crisis could be due to a serious deficit in the BoP with the reserve currency country because the fixed exchange rate regime does not follow market mechanisms and the lack of transparency of the system, which may also be mismanaged by the monetary authority, could cause high expectations of devaluation of the local currency. This anticipation from investors could lead to capital flight (swapping of domestic assets for foreign assets) and cause the fixed exchange rate regime to collapse.

Under a fixed exchange rate regime, government has less control of its monetary policy for either expansion or contraction to maneuver its economy because the local currency needs to be maintained at a certain level relative to the foreign currency to keep the fixed exchange rate valid. However, the system may be suitable for less developed nations where the benefit of running a fixed exchange regime exceeds its cost in an economy that seeks an optimal level of development and control.

Bibliography:

Gianluca Benigno, Pierpaolo Benigno, and Fabio Ghironi, “Interest Rate Rules for Fixed Exchange Rate Regimes,” Journal of Economic Dynamics and Control (v.31/7, 2007);
Ronald MacDonald, Exchange Rate Economics: Theories and Evidence (Routledge, 2007);
Inci Ötker and David Vávra, Moving to Greater Exchange Rate Flexibility: Operational Aspects Based on Lessons from Detailed Country Experiences (International Monetary Fund, 2007);
Sergio Rebelo and Carlos A. Vegh, “When Is It Optimal to Abandon a Fixed Exchange Rate?” Review of Economic Studies (v.75/3, 2008);
Romain Veyrune, Fixed Exchange Rate and the Autonomy of Monetary Policy: The Franc Zone Case (IMF, 2007).

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