Fixed Exchange Rate - Explained
What is a Fixed Exchange Rate?
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Table of ContentsWhat is a Fixed Exchange Rate?How is the Fixed Exchange Rate Used?Academic Research on Fixed Exchange Rate System
What is a Fixed Exchange Rate?
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 countrys central bank controls the exchange rate for the currency to maintain economic stability and promote growth.
How is the Fixed Exchange Rate Used?
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 currencys supply increases. To stabilize the demand for the currency, the central bank will buy the domestic currencys 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.
- Exchange Rate
- Equation of Exchange (Economics)
- Real Effective Exchange Rate (REER)
- Limited Flexibility Exchange Rate System