Fixed Exchange Rate System – Definition
A fixed exchange rate system, also known as Fixed Exchange Rate System (FERS) or Pegged Exchange Rate (PER), is when the value of a currency is fixed to (the same as) the value of some other single currency (or group of currencies) or to some particular asset (such as gold or other precious metals). A country’s central bank controls the exchange rate for the currency to maintain economic stability and promote growth.
A Little More on What is the Fixed Exchange Rate
The objective of a Fixed Exchange Rate System is to maintain the value of a currency in a narrow band.
When a country keeps the value of its currency at a Fixed Exchange Rate to the United States dollar, it is referred to as a dollar peg.
The central bank of a country controls its currency value to make it rise and fall according to the dollar value.
Fixing the currency of a country is an effective strategy to eliminate or minimize the inflationary trends. It is a constraint which stops the supply of domestic money from increasing too sharply.
Generally when a country raises its money supply, rates of interest decrease. The investors start transferring their savings abroad. So, in the Foreign Exchange Market, the domestic currency’s supply increases.
To stabilize the demand for the currency, the central bank will buy the domestic currency’s excess supply on the market. This is to balance the forces of supply and demand at the fixed exchange rate. In these circumstances, the central bank will run a payments deficit balance that results in a decrease in the supply of domestic money.
To finance the budget deficit, the central bank will print money. The net effect on the supply of money is the supply of money increases proportionally to the growth rate in the economy. If this is the case, little or no inflation should occur. So, a Fixed Exchange Rate overcomes the inflationary trends.
For the fixed exchange rate to decrease inflation over a long time period, it must avoid devaluations. In the event of devaluation, the country can support a fairly high money supply level. In turn, it will affect the inflation rate positively. If there are frequent devaluations, then a country will likely follow a floating exchange rate system.
References for Fixed Exchange Rate
Academic Research on Fixed Exchange Rate System
External shocks, balance sheet contagion, and speculative attack on the pegged exchange rate system, Ma, Y. (2009). Review of Development Economics, 13(1), 87-98. The Pegged exchange rate can collapse in an unstable environment through the boiling frog effect and the contagion of the balance sheet, even if the domestic policy is good. If agents predict it, chances of a speculative attack are possible. For outflow shock of capital, an effective equity control can be applied. The deregulation of the capital account is becoming more stable in a deficit shock of the current account. This research also differentiates the impact of capital movement with asset sustainability since their effects vary on the peg totally.
• External shocks and collapsing the pegged exchange rate system, Sun, H., & Ma, Y. (2004). The monetary model emphasises on the external factors which collapse the Pegged ER system. This system cannot survive in a continuous external shock. The peg collapse even in case of sound domestic policy. The government policy options are subject to the nature of the shock. Capital control becomes effective only if the shock becomes capital outflow. A deficit shock of the current account needs more capital flow in order to avoid depleted foreign reserves. This paper provides differences in capital mobility and asset sustainability effects.
• Analysis on Advantage and Disadvantage of Pegged–exchange–rate System in Hong Kong, Shu-zhang, S. U. N. (2000). ECONOMIC SURVEY, 2, 018. This paper makes a detailed analysis of the merits and demerits of Hong Kong’s Pegged Exchange Rate System, its trade policies and factors affecting the market.
• The relationship between China’s pegged exchange rate system and China’s bilateral trade with USA, Lu, M. (2004). In this article, the author evaluates the relation in the Pegged Exchange Rate System of China and its bilateral trade with the United States of America.
• Speculative attacks on pegged exchange rates: an empirical exploration with special reference to the European Monetary System, Eichengreen, B., Rose, A. K., & Wyplosz, C. (1994). National Bureau of economic research. In this study, statistical analysis has been shown related to the speculative attacks on the Pegged ER in twenty-two countries between 1967-1992. The authors consider crisis or speculative attacks as large movements in the interest rates, international reserves and exchange rates. This paper contains stylised facts regarding the univariate behaviour of many economic variables. The Null Hypothesis can’t be rejected because the main macroeconomic variables in the crisis and non-crisis era have large differences. The authors attach these findings with the theoretical work on the crisis of BOP.
• Real exchange–rate variability under pegged and floating nominal exchange–rate systems: An equilibrium theory, Stockman, A. C. (1988, January). In Carnegie-Rochester Conference Series on Public Policy (Vol. 29, pp. 259-294). North-Holland. This paper presents new aspects of great changes in the real exchange rates in pegged, nominal and floating exchange rate systems. It focuses on the tendency of governments to apply financial restrictions as well as global trade restrictions for the purpose of BoP (Balance of Payment) in the Pegged exchange rate. Specifically, these restrictions are more when countries bear the loss of international reserves. It causes a crisis in the balance of payment. This means that the real exchange rate will change less in the Pegged exchange rate as compared to the floating one.
• Exchange rate regimes: is the bipolar view correct?, Fischer, S. (2001). Journal of economic perspectives, 15(2), 3-24. The 2 corner solution also called Bipolar of exchange rate states that regimes of intermediate policy in floating pegs and hard pegs are not sustainable. This paper presents an argument that Bipolar proponents are exaggerating their view. Truth is that for open to global capital flows countries softly pegged rates are prone to crisis. They are not sustainable in a long period of time. However, a large type of flexible exchange rate arrangements is possible. In many countries, the exchange rate and monetary policy must not be ignorant of the movements of the exchange rate.
• Exchange rates and financial fragility, Eichengreen, B., & Hausmann, R. (1999). (No. w7418). National bureau of economic research. This paper makes an analysis of 3 views related to the relation in financial fragility and exchange rate. First is the Moral Hazard Hypothesis that states Pegged exchange rates provide implicit insurance for exchange risk, so encourage taking and giving reckless loans. 2nd is the Original Sin Hypothesis that focuses on the incompleteness in the exchange markets preventing the domestic currency to be borrowed abroad or for a long time. 3rd is Commitment Problem Hypothesis that finds financial crisis as a result of the weakness of the organizations which consider commitment issues. The authors present their implications in this regard.
• The firm under pegged and floating exchange rates, Aliber, R. Z. (1976). The Scandinavian Journal of Economics, 309-322. This paper explains the effects of floating exchange rates on global investment and trade by making a comparison in risks and costs faced by traders. Under the floating rate, transaction costs are 5 to 10 times higher with deliberate increases attached to more volatile currencies. Under the 2 ER systems, we measure the exchange risk by making a comparison of the average forecast errors in the spot and forward rates at the time of maturity. Ultimately, price risk has been shown higher in the floating ER system.
• Fluctuating exchange rates and the pricing of exports, Baron, D. P. (1976). Economic Inquiry, 14(3), 425-438. This study examines an exporter’s invoicing decisions in the Pegged ER and a freely fluctuating ER system. The exporter, under Pegged Exchange Rate, May equally invoice in his home currency or the foreign clients’ currency as the 2 prices relate by Pegged ER. However, the selection of an invoicing policy under fluctuating ER is vital and definitely influences the trade level. The comparison of optimal prices is made using each strategy. The response of exporter to state policy tools is characterised.
• Exchange–rate policy for developing countries, Chang, R., & Velasco, A. (2000). American Economic Review, 90(2), 71-75. This research is carried out to examine the exchange rate policy devised for developing countries. To what extent, it is effective and how to implement it in the real scenario.