What exactly is a fixed exchange rate?
Governments or central banks set fixed exchange rates to link the official exchange rate to another country’s currency or gold prices. A fixed exchange rate system’s goal is to limit a currency’s value.
Understanding Fixed Exchange Rates
Fixed rates offer more assurance for exporters and importers. Long-term fixed rates help the government maintain low inflation by lowering interest rates and boosting trade and investment.
Most developed countries use floating exchange rate systems, where the forex market determines the currency price. These nations adopted this approach in the early 1970s, whereas emerging economies use fixed rates.
From WWII to the early 1970s, the Bretton Woods Agreement anchored exchange rates to the U.S. dollar, tied to gold prices.
In the 1950s and 1960s, the U.S.’ postwar surplus transformed into a deficit, making periodic exchange rate changes under the agreement inadequate. After President Richard Nixon ended the gold standard in 1973, the U.S. adopted variable rates.
Monetary Union Origins
The European exchange rate mechanism (ERM) was created in 1979 to prepare for monetary unification and the euro. Germany, France, the Netherlands, Belgium, and Italy agreed to keep their currency rates within 2.25% of a fixed point.
The U.K. joined in October 1990 at an exorbitant conversion rate and left two years later. The founding euro members changed from their national currencies to the ERM central rate on January 1, 1999. Euros trade freely with other major currencies, whereas currencies of nations seeking to join trade under ERM II
Bad Things About Fixed Exchange Rates
Fixed-rate systems are commonly used in developing countries to minimize speculation and provide stability. A stable system enables importers, exporters, and investors to plan without currency fluctuations.
However, a fixed-rate system restricts central banks’ capacity to modify interest rates for economic development. Fixed-rate systems avoid market movements due to currency overvaluation or undervaluation. To effectively administer a fixed-rate system, a sizable reserve pool is needed to maintain the currency during times of strain.
An unreasonable official currency rate might result in a parallel, unofficial, or dual exchange rate. A substantial discrepancy between official and unofficial rates can cause currency shortages and repeated devaluations. These can destabilize an economy more than floating exchange rate adjustments.
A Fixed Exchange Rate in Practice
Issues with Fixed Exchange Rates
According to BBC News, after losing 8% against the dollar in one day, Iran imposed a fixed currency rate of 42,000 rials on the dollar in 2018. The government eliminated the difference between dealers’ 60,000 rials and the official rate 37,000.
- The goal of a fixed exchange rate system is to limit the value of a currency.
- Fixed exchange rates give exporters and importers more assurance and help the government control inflation.
- Many developed nations adopted floating exchange rates in the early 1970s.