Fixed Exchange Rate
A fixed exchange rate is an arrangement in which the value of a country's currency is pegged to another currency, to a basket of currencies, or to a commodity such as gold. The monetary authority commits to maintaining the parity, typically by intervening in the foreign exchange market and by adjusting domestic monetary conditions as needed.
Mechanisms of Maintenance
A fixed rate is maintained through intervention and monetary policy. If the currency weakens, the central bank sells foreign exchange reserves and buys domestic currency, and may raise domestic interest rates to attract capital. If the currency strengthens, it buys foreign exchange and sells domestic currency, accumulating reserves and lowering interest rates.
In a currency board, the commitment is stronger: the domestic money supply is backed by foreign reserves at a fixed rate, and the central bank forgoes discretionary monetary policy. In a currency union, member countries adopt a common currency, eliminating exchange rate variation entirely among them and delegating monetary policy to a shared central bank.
Benefits
Fixed rates reduce exchange rate uncertainty, facilitating trade and cross-border investment. They provide a nominal anchor for monetary policy, helping to control inflation when domestic institutions lack credibility. For small open economies with strong economic linkages to a partner, fixing the exchange rate can stabilise relative prices and support integration.
Fixed rates also reduce the risk premium embedded in interest rates, lowering the cost of borrowing for the government and for firms, at least while the peg is credible. This can support investment and growth.
Costs and Vulnerabilities
The principal cost is the loss of independent monetary policy, as implied by the policy trilemma when capital is mobile. The domestic interest rate must be set to maintain the parity, regardless of domestic conditions. If the domestic economy is hit by a shock different from that affecting the anchor country, monetary policy cannot respond, and adjustment must come through prices, wages, and quantities.
Fixed rates are vulnerable to speculative attack when the parity becomes inconsistent with fundamentals. Defending the peg can require very high interest rates, which may damage the domestic economy and banking system. If the defence fails, the resulting devaluation can be abrupt and disruptive.
Historical and Contemporary Examples
The classical gold standard and the Bretton Woods system were historical fixed rate regimes. Contemporary examples include currency boards in several economies and the currency union of the euro area. Experience shows that the durability of a fixed rate depends on the credibility of the commitment and on the consistency of the parity with underlying economic conditions.
Credibility and the Cost of Defence
The credibility of a fixed rate depends on whether markets believe the commitment will be maintained. If credible, the peg can deliver low inflation and low interest rates. If not, it invites speculation. Credibility is reinforced by institutional arrangements, such as currency boards and central bank independence, and by consistent fiscal and monetary policies.
Defending a peg can be costly. Raising interest rates to attract capital may contract domestic demand and weaken the banking system. Using reserves may deplete them and invite further attack. Imposing capital controls may be effective temporarily but can have long-term costs. The choice among these tools depends on the sources of pressure and the objectives of policy.
Currency Boards
A currency board is a monetary arrangement in which the domestic money supply is fully backed by foreign reserves and the board stands ready to exchange domestic for foreign currency at a fixed rate. The arrangement removes discretionary monetary policy and provides a strong commitment to the peg. It has been adopted by several economies, often after periods of instability, and has been credited with restoring credibility.
The rigidity of a currency board is both its strength and its weakness. It provides a hard commitment but limits the ability to respond to shocks, and it leaves the banking system without a lender of last resort unless arrangements are made separately. Exit from a currency board requires careful management to avoid destabilising expectations.
Devaluations and Revaluations
Adjustments to a fixed rate, through devaluation or revaluation, are sometimes necessary when the parity becomes inconsistent with fundamentals. Devaluation can restore competitiveness and reduce external imbalances, but it raises the cost of foreign currency debt, may accelerate inflation, and can damage credibility. Revaluation can reduce inflationary pressure but may harm export sectors.
The timing and communication of adjustments are critical. Surprise devaluations can generate capital flight and contagion, while preannounced adjustments risk speculative pressure in advance. The management of expectations is central to the success of parity changes.
Fixed Rates and Financial Stability
Fixed rates can contribute to financial instability when they encourage excessive foreign currency borrowing. Borrowers may underestimate currency risk when the peg appears secure, accumulating liabilities that become unsustainable if the peg is abandoned. This pattern has featured in several crises, and it motivates macroprudential measures to limit currency mismatches and to build buffers against sudden reversals.