The term “fixed exchange rate” is not new as it often pops up. But what does it mean, and why is it significant? This article explains the concept of fixed exchange rates in simple terms, how it works and the difference between fixed and floating exchange rate.

What is a Fixed Exchange Rate?

A fixed exchange rate is a monetary policy system where a country’s currency value is tied to another currency, a basket of currencies, or a commodity like gold. This means the exchange rate remains stable and does not fluctuate in response to market demand or supply.

For example, if a country pegs its currency to the US dollar at a fixed rate of 1:1, this means one unit of its currency always equals one US dollar. Governments or central banks enforce this fixed rate by actively intervening in the foreign exchange market.

How Does a Fixed Exchange Rate Work?

Governments maintain fixed exchange rates through foreign currency reserves and monetary policy adjustments. Here’s how:

1. Currency Pegging: A country announces the fixed rate and ties its currency to another currency or a commodity.
2. Market Intervention: If the market value of the currency deviates from the peg, the central bank steps in. For example, it might buy its currency using foreign reserves to strengthen its value.
3. Interest Rate Adjustments: Central banks may tweak interest rates to attract foreign investment, stabilizing the exchange rate.

Advantages 

1. Stability: Fixed rates provide predictability in international trade and investment. Businesses know the value of currencies won’t suddenly shift.
2. Inflation Control: By tying a currency to a stable foreign currency, countries can control inflation more effectively.
3. Encourages Trade: With stable exchange rates, businesses and investors face fewer risks when trading across borders.

Disadvantages

1. Economic Rigidity: Fixed rates limit a country’s ability to respond to economic shocks, such as sudden changes in commodity prices.
2. Foreign Reserve Dependency: Maintaining a fixed rate requires large reserves of foreign currency.
3. Speculative Attacks: If investors doubt a country’s ability to maintain its peg, they may sell the currency en masse, destabilizing the system.

Fixed Exchange Rate vs. Floating Exchange Rate

In contrast to fixed exchange rates, floating exchange rates are determined by market forces like supply and demand. Each system has its pros and cons, and countries choose one based on their economic priorities.

Examples of Fixed Exchange Rate Systems

1. Hong Kong Dollar (HKD): The Hong Kong Monetary Authority pegs the HKD to the US dollar at approximately 7.8 HKD/USD.
2. Danish Krone (DKK): Denmark pegs its currency to the euro within a narrow band of fluctuation.
3. Saudi Riyal (SAR): The Saudi Riyal is pegged to the US dollar at a fixed rate of 3.75 SAR/USD.

FAQs 

1. Why do countries use fixed exchange rates? Countries use fixed rates to stabilize their economies, control inflation, and encourage international trade.
2. Are fixed exchange rates sustainable? Sustainability depends on economic conditions and a country’s ability to maintain foreign reserves.
3. How do fixed exchange rates impact consumers? Stable rates make imported goods predictable in price, benefiting consumers and businesses alike.