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Fixed Exchange Rate Definition
When the central bank or the government bounds the official exchange rate to the currency of another country or the gold prices, a situation called a “fixed exchange rate” arises. This tends to limit the value of a currency within a slight band.
A Little More on What is a Fixed Exchange Rate
Fixed rates tend to lead to low inflation, keeping interest rates low in the long run, and increasing investment. Developing economies tend to adopt fixed rates to ensure stability, reduce speculation, and to encourage investors. However, this system blocks central banks from making strategic adjustments in interest rates as per economic need. Fixed rates also require large currency reserves to back the currency in times of pressure.
The Bretton Woods Agreement, employed after WWII until the 1970s, linked member nations exchange rates to the US Dollar value, which was fixed to gold prices. The gold era ended in 1973 and was replaced by floating rates.
In 1979, the European Union was created along with the Euro currency. The EU also launched the European Exchange Rate Mechanism (ERM) as part of the Europen Monetary System (EMS). The member nations (including France, Italy, Spain, Netherlands and Germany) consented to follow +/- 2.25% currency rates. The system was designed to reduce exchange rate variability. The UK, joined 1990 but withdraw after 2 years.
References for Fixed Exchange Rates
Academic Research on Fixed Exchange Rate
Domestic financial policies under fixed and under floating exchange rates, Fleming, J. M. (1962). Staff Papers, 9(3), 369-380. This article shows that the expansion resulting from a given increase in money supply will always be stronger if the country has a fluctuating exchange rate than if it has a fixed rate.
The mirage of fixed exchange rates, Obstfeld, M., & Rogoff, K. (1995). Journal of Economic perspectives, 9(4), 73-96. This paper discusses the profound difficulties of maintaining fixed exchange rates in a world of expanding global capital markets. The authors also discuss the small number of successful fixers.
Fixed exchange rates as a means to price stability: what have we learned?, Svensson, L. E. (1994). European Economic Review, 38(3-4), 447-468. The paper discusses what we have learned from last year’s currency crises in ERM and the Nordic countries about fixed exchange rates as a means to achieve price stability. After discussing the explanations for the crises, the paper concludes that fixed exchange rates are not a shortcut to price stability. Monetary stability and credibility have to be built at home and cannot easily be imported from abroad.
Capital mobility and stabilization policy under fixed and flexible exchange rates, Mundell, R. A. (1963). Canadian Journal of Economics and Political Science/Revue canadienne de economiques et science politique, 29(4), 475-485. This paper analyses the theoretical and practical implications of the increased mobility of capital.
Hedging and financial fragility in fixed exchange rate regimes, Burnside, C., Eichenbaum, M., & Rebelo, S. (2001). European Economic Review, 45(7), 1151-1193. Currency crises that coincide with banking crises tend to share at least three elements. First, banks have a currency mismatch between their assets and liabilities. Second, banks do not completely hedge the associated exchange rate risk. Third, there are implicit government guarantees to banks and their foreign creditors. This paper argues that the first two features arise from banks’ optimal response to government guarantees.
The instability of fixed exchange rate systems when raising the nominal interest rate is costly, Bensaid, B., & Jeanne, O. (1997). European Economic Review, 41(8), 1461-1478. This paper points to a vicious circle which may arise when a government tries to defend its currency by raising the nominal interest rate in a fixed exchange rate system. It presents a stylised model in which raising the nominal interest rate helps to maintain the parity, but is costly for the government. It provides some informal evidence showing that this model explains some features of the 1992–93 EMS crisis.
Fixed exchange rates: Credibility, flexibility and multiplicity, Velasco, A. (1996). European economic review, 40(3-5), 1023-1035. This paper surveys recent work on the sustainability of fixed exchange rates. It considers a dynamic version the Barro-Gordon framework, in which the level of a state variable (in this case debt) determines the pay-offs available to the government at each point in time.
The operation and collapse of fixed exchange rate regimes, Garber, P. M., & Svensson, L. E. (1995). Handbook of international economics, 3, 1865-1911. This chapter discusses the operation and collapse of fixed exchange rate regimes. It reports recent research contributions to the understanding of the dynamics of a fixed exchange rate system.
The effect of fixed exchange rates on monetary policy, Shambaugh, J. C. (2004). The Quarterly Journal of Economics, 119(1), 301-352. To investigate how a fixed exchange rate affects monetary policy, this paper classifies countries as pegged or “non pegged” and examines whether a pegged country must follow the interest rate changes in the base country. This study uses actual behavior, not declared status, for regime classification; expands the sample including base currencies other than the dollar; examines the impact of capital controls, as well as other control variables; considers the time series properties of the data carefully; and uses cointegration and other levels-relationship analysis to provide additional insights.
On the renminbi: the choice between adjustment under a fixed exchange rate and adjustment under a flexible rate, Frankel, J. (2005). (No. w11274). National Bureau of Economic Research. This paper finds that, typically across countries, the gaps between fixed and flexible exchange rates are corrected halfway, on average, over subsequent decades from when they were first observed.
An interest rate defense of a fixed exchange rate?, Flood, R. P., & Jeanne, O. (2005). Journal of International Economics, 66(2), 471-484. This paper shows how to adapt the first-generation framework to allow for an interest rate defense of government exchange-rate commitment. It is shown that increasing domestic currency interest rate before the occurrence of speculative attack makes domestic assets more attractive according to an asset substitution effect, but weakens the domestic currency by increasing the government’s fiscal liabilities.