A fixed exchange rate, often called a pegged exchange rate or pegging, is a type of exchange rate regime in which a currency's value is fixed, or pegged, by a monetary authority against the value of another currency, a basket of other currencies, or another measure of value, such as gold or silver.
There are benefits and risks to using a fixed exchange rate system. A fixed exchange rate is typically used to stabilize the exchange rate of a currency by directly fixing its value in a predetermined ratio to a different, more stable, or more internationally prevalent currency (or currencies) to which the currency is pegged. In doing so, the exchange rate between the currency and its peg does not change based on market conditions, unlike in a floating (flexible) exchange regime. This makes trade and investments between the two currency areas easier and more predictable and is especially useful for small economies that borrow primarily in foreign currency and in which external trade forms a large part of their GDP.
A fixed exchange rate system can also be used to control the behavior of a currency, such as by limiting rates of inflation. However, in doing so, the pegged currency is then controlled by its reference value. As such, when the reference value rises or falls, it then follows that the values of any currencies pegged to it will also rise and fall in relation to other currencies and commodities with which the pegged currency can be traded. In other words, a pegged currency is dependent on its reference value to dictate how its current worth is defined at any given time. In addition, according to the Mundell–Fleming model, with perfect capital mobility, a fixed exchange rate prevents a government from using domestic monetary policy to achieve macroeconomic stability.
In a fixed exchange rate system, a country's central bank typically uses an open market mechanism and is committed at all times to buy and sell its currency at a fixed price in order to maintain its pegged ratio and, hence, the stable value of its currency in relation to the reference to which it is pegged. To maintain a desired exchange rate, the central bank, during a time of private sector net demand for the foreign currency, sells foreign currency from its reserves and buys back the domestic money. This creates an artificial demand for the domestic money, which increases its exchange rate value. Conversely, in the case of an incipient appreciation of the domestic money, the central bank buys back the foreign money and thus adds domestic money into the market, thereby maintaining market equilibrium at the intended fixed value of the exchange rate.
In the 21st century, the currencies associated with large economies typically do not fix (peg) their exchange rates to other currencies. The last large economy to use a fixed exchange rate system was the People's Republic of China, which, in July 2005, adopted a slightly more flexible exchange rate system, called a managed exchange rate. The European Exchange Rate Mechanism was also used on a temporary basis to establish a final conversion rate against the euro from the local currencies of countries joining the Eurozone.Cohen, Benjamin J, "Bretton Woods System", Routledge Encyclopedia of International Political EconomyWhite, Lawrence. Is the Gold Standard Still the Gold Standard among Monetary Systems?, CATO Institute Briefing Paper no. 100, 8 Feb 2008
History
Chronology Timeline of the fixed exchange rate system:
1880–1914 Classical gold standard period April 1925 United Kingdom returns to gold standard October 1929 United States stock market crashes September 1931 United Kingdom abandons gold standard July 1944 Bretton Woods Conference March 1947 International Monetary Fund comes into being August 1971 United States suspends convertibility of dollar into gold – Bretton Woods system collapses December 1971 Smithsonian Agreement March 1972 European snake with 2.25% band of fluctuation allowed March 1973 Managed float regime comes into being April 1978 Jamaica Accords take effect September 1985 Plaza Accord September 1992 United Kingdom and Italy abandon European Monetary System (EMS) August 1993 European Monetary System allows ±15% fluctuation in exchange rates
Gold standard
The gold standard is a monetary system in which a country's currency or paper money has a value directly linked to gold. With the gold standard, countries agreed to convert paper money into a fixed amount of gold upon demand.
Bretton Woods system
The Bretton Woods System is a set of unified rules and policies that provided the framework necessary to create fixed international currency exchange rates. Essentially, the agreement called for the newly created IMF to determine the fixed rate of exchange for currencies around the world
Current monetary regimes A current monetary system is a system by which a government provides money in a country's economy. Modern monetary systems usually consist of the national treasury, the mint, the central banks and commercial banks.
Mechanisms
Open market trading Typically, a government wanting to maintain a fixed exchange rate does so by either buying or selling its own currency on the open market. This is one reason governments maintain reserves of foreign currencies.
If the exchange rate drifts too far above the fixed benchmark rate (it is stronger than required), the government sells its own currency (which increases supply) and buys foreign currency. This causes the price of the currency to decrease in value (Read: Classical Demand-Supply diagrams). Also, if they buy the currency it is pegged to, then the price of that currency will increase, causing the relative value of the currencies to approach what is intended.
If the exchange rate drifts too far below the desired rate, the government buys its own currency in the market by selling its reserves. This places greater demand on the market and causes the local currency to become stronger, hopefully back to its intended value. The reserves they sell may be the currency it is pegged to, in which case the value of that currency will fall.
Fiat Another, less used means of maintaining a fixed exchange rate is by simply making it illegal to trade currency at any other rate. This is difficult to enforce and often leads to a black market in foreign currency. Nonetheless, some countries are highly successful at using this method due to government monopolies over all money conversion. This was the method employed by the Chinese government to maintain a currency peg or tightly banded float against the US dollar. China buys an average of one billion US dollars a day to maintain the currency peg. Throughout the 1990s, China was highly successful at maintaining a currency peg using a government monopoly over all currency conversion between the yuan and other currencies.
Open market mechanism example
Excess demand for dollars
Excess supply of dollars
Types of fixed exchange rate systems
The gold standard
The gold standard is the pegging of money to a certain amount of gold.
Price specie flow mechanism
Reserve currency standard
Currency board arrangements are the most widespread means of fixed exchange rates. Currency boards are considered hard pegs as they allow central banks to cope with shocks to money demand without running out of reserves. CBAs have been operational in many nations including: Hong Kong (since 1983); Argentina (1991 to 2001); Estonia (1992 to 2010); Lithuania (1994 to 2014); Bosnia and Herzegovina (since 1997); Bulgaria (1997 to 2025); Bermuda (since 1972); Denmark (since 1945); Brunei (since 1967)Salvatore, Dominick; Dean, J; Willett, T. The Dollarisation Debate (Oxford University Press, 2003)
Gold exchange standard
Hybrid exchange rate systems
Basket-of-currencies
Crawling pegs
Pegged within a band
Currency boards
Currency substitution
Monetary co-operation Monetary co-operation is the mechanism in which two or more monetary policies or exchange rates are linked, and can happen at regional or international level.Bergsten, C. F., & Green, R. A. (2016). Overview International Monetary Cooperation: Peterson Institute for International Economics The monetary co-operation does not necessarily need to be a voluntary arrangement between two countries, as it is also possible for a country to link its currency to another countries currency without the consent of the other country. Various forms of monetary co-operations exist, which range from fixed parity systems to monetary unions. Also, numerous institutions have been established to enforce monetary co-operation and to stabilise exchange rates, including the European Monetary Cooperation Fund (EMCF) in 1973European Monetary Cooperation Fund on Wikipedia and the International Monetary Fund (IMF)Von Mises, L. (2010). International Monetary Cooperation. Mises Daily Articles. Retrieved from https://mises.org/library/international-monetary-cooperation
Monetary co-operation is closely related to economic integration, and are often considered to be reinforcing processes.Berben, R.-P., Berk, J. M., Nitihanprapas, E., Sangsuphan, K., Puapan, P., & Sodsriwiboon, P. (2003). Requirements for successful currency regimes: The Dutch and Thai experiences: De Nederlandsche Bank However, economic integration is an economic arrangement between different regions, marked by the reduction or elimination of trade barriers and the coordination of monetary and fiscal policies, whereas monetary co-operation is focussed on currency linkages. A monetary union is considered to be the crowning step of a process of monetary co-operation and economic integration. In the form of monetary co-operation where two or more countries engage in a mutually beneficial exchange, capital among the countries involved is free to move, in contrast to capital controls. Monetary co-operation is considered to promote balanced economic growth and monetary stability,James, H. (1996). International monetary cooperation since Bretton Woods: International Monetary Fund but can also work counter-effectively if the member countries have (strongly) differing levels of economic development. Especially European and Asian countries have a history of monetary and exchange rate co-operation,Volz, U. (2010). Introduction Prospects for Monetary Cooperation and Integration in East Asia. Cambridge, Massachusetts: MIT Press however the European monetary co-operation and economic integration eventually resulted in a European monetary union.
Example: The Snake In 1973, the currencies of the European Economic Community countries, Belgium, France, Germany, Italy, Luxemburg and the Netherlands, participated in an arrangement called the Snake. This arrangement is categorized as exchange rate co-operation. During the next 6 years, this agreement allowed the currencies of the participating countries to fluctuate within a band of plus or minus 2¼% around pre-announced central rates. Later, in 1979, the European Monetary System (EMS) was founded, with the participating countries in ‘the Snake’ being founding members. The EMS evolves over the next decade and even results into a truly fixed exchange rate at the start of the 1990s. Around this time, in 1990, the EU introduced the Economic and Monetary Union (EMU), as an umbrella term for the group of policies aimed at converging the economies of member states of the European Union over three phases Economic and Monetary Union of the European Union on Wikipedia. This led to the introduction of the Eurozone and Euro in 1999.
Example: The baht-U.S. dollar co-operation