Fixed Exchange Rate

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Fixed Exchange Rates

In a fixed exchange rate system, the government or central bank chooses a value that it wants the currency to be stable at. There are two ways to do this: a soft peg or hard peg.

Soft peg

A soft peg is where the government usually allows the exchange rate to be set by the market, but in in some cases, the central bank will intervene with the market.
The central bank could increase the supply of the domestic currency (£) or buy other currencies.
- The Chinese yuan is softly pegged to the US dollar.
- The Swiss franc was softly pegged to the Euro until 2015, when it abandoned the peg.

Hard peg

With a hard peg policy, the central bank sets a fixed and unchanging value for the exchange rate.
The central bank will have to buy and sell currency using its currency reserves to keep the fixed exchange rate at the value of the hard peg.
- Hong Kong uses a currency board to keep a hard peg to the US dollar. The Hong Kong Monetary Authority fixes its exchange rate to the USD at HKD7.8.

Advantage of Fixed Exchange Rates

Fixed rates provide stability for firms and households and encourage governments to act more responsibly.

Stability for firms and households

Stability in the exchange rate can encourage firms to invest and households to spend because of the confidence/certainty it builds.
Transactions that involve world trade will rise in particular.

Encourage government responsibility

There is no correction of current account deficits, and so a fixed rate forces a government to act more responsibly.
Governments will be forced to use supply-side and fiscal policy to control the factors that lead to pressure on the exchange rate (e.g high inflation). This may be positive or negative if controlling inflation leads to high unemployment.

Disadvantages of Fixed Exchange Rates

There are a number of negative consequences of using a fixed exchange rate.

Lose power over monetary policy

If a central bank uses monetary policy (interest rates) to alter the exchange rate, then it cannot use monetary policy to address issues of inflation or recession at the same time.
- For example, a government may want to depreciate the currency to make exports more competitive by reducing the interest rate, but this would have the side-effect of potentially increasing inflation through increased consumer spending (C) and investment (I), as well as higher import prices.

Speculative pressure

Holding large reserves of a currency and intervening in the foreign exchange market has a severe opportunity cost.
A hard peg policy will not allow fluctuations. But speculators may try to force a country to leave its peg if they sense an incorrect value.
This happened on 'Black Wednesday' in 1992 when the UK was forced to abandon its peg to the currency of Germany. This cost the UK government billions of pounds in the process of artificially boosting the Pound by spending foreign reserves.

Unstable current account

Unlike with floating exchange rates, the current account balance isn't corrected by the natural mechanism of changing the relative price of imports and exports.
If there are lots of imports or exports, the 'price' of the currency does not change. This means fixed exchange rates fail to adjust for changes in competitiveness over time.