Definition of Fixed Exchange Rate
A fixed exchange rate is a type of exchange rate regime wherein a nation’s currency value is tied or pegged to another major currency, such as the U.S. dollar, the euro, or gold. Governments control and maintain this rate by buying or selling their own currency on the international market to offset fluctuations. This system provides stability in international prices for trade and investment, making it easier for countries to plan and budget.
Examples of Fixed Exchange Rate
- Hong Kong Dollar Pegged to the US Dollar: The Hong Kong Monetary Authority (HKMA) maintains the Hong Kong dollar’s value within a narrow range against the US dollar, ensuring stability in their trading relationship.
- Bahraini Dinar Pegged to the US Dollar: The Central Bank of Bahrain pegs the Bahraini dinar at a fixed rate to the US dollar to stabilize its economy.
- Chinese Yuan Pegged to a Basket of Currencies: For a significant period, China’s currency, the yuan or renminbi, was fixed primarily to the US dollar but is now pegged to a basket of currencies to balance trade competitiveness.
Frequently Asked Questions (FAQs)
What is the purpose of a fixed exchange rate?
A fixed exchange rate is designed to provide greater certainty for exporters and importers, reduce risks of foreign exchange fluctuations, and ensure economic stability.
How does a government maintain a fixed exchange rate?
Governments maintain a fixed exchange rate by intervening in the foreign exchange market. They buy or sell their own currency to keep its value within a predetermined range.
What are the main advantages of a fixed exchange rate?
- Stability: Offers predictable exchange rates beneficial for international trade and investment.
- Inflation Control: Can curb runaway inflation by anchoring the currency’s value.
- Economic Integration: Facilitates easier comparison of prices with trading partners.
What are the disadvantages of a fixed exchange rate?
- Limited Flexibility: Restricts a country’s ability to adjust monetary policy freely.
- Foreign Reserves Dependency: Requires substantial foreign exchange reserves to defend the peg.
- Speculative Attacks: Vulnerable to speculative attacks if the rate is seen as unsustainable.
How does a fixed exchange rate compare to a floating exchange rate?
A fixed exchange rate is maintained through government intervention, while a floating exchange rate is determined by market forces without direct government control.
Floating Exchange Rate
A floating exchange rate is determined by the open market through supply and demand. Unlike a fixed exchange rate, it fluctuates based on economic conditions but is not stabilized directly by government intervention.
Currency Peg
A currency peg is another term for a fixed exchange rate - it refers to the practice of fixing the exchange rate of one currency to another.
Devaluation
A reduction in the value of a currency with respect to other monetary units, usually enacted by the government in a fixed exchange rate system.
Online References
Suggested Books for Further Studies
- “Exchange Rate Regimes: Choices and Consequences” by Atish R. Ghosh and Anne-Marie Gulde-Wolf
- “The Economics of Exchange Rates” by Lucio Sarno and Mark P. Taylor
- “Fixed or Flexible Exchange Rates? History and Perspectives” edited by Marvin A. Goodfriend and Eswar S. Prasad
Accounting Basics: Fixed Exchange Rate Fundamentals Quiz
### What is a fixed exchange rate?
- [ ] An exchange rate determined purely by market forces.
- [x] An exchange rate pegged to another currency or standard by government policy.
- [ ] An unpredictable and volatile exchange rate.
- [ ] An agreement between two private companies for currency exchange.
> **Explanation:** A fixed exchange rate is set and maintained by a government and usually pegged to another currency or a basket of currencies. It is predictable and provides stability.
### Why might a country adopt a fixed exchange rate?
- [x] To ensure currency stability and prevent excessive fluctuations.
- [ ] To allow free market conditions to determine exchange rates.
- [ ] To make its currency more appealing to speculators.
- [ ] To increase the value of its currency effortlessly.
> **Explanation:** Countries adopt fixed exchange rates to provide economic stability, which minimizes the risks associated with fluctuating exchange rates.
### Which method is primarily used to maintain a fixed exchange rate?
- [ ] Letting the exchange rate float freely.
- [x] Government intervention by buying and selling currencies.
- [ ] Imposing heavy taxes on foreign currency transactions.
- [ ] Regulating international trade extensively.
> **Explanation:** Governments maintain a fixed exchange rate through active intervention by buying and selling their own currency to keep the rate stable.
### What is one risk of maintaining a fixed exchange rate?
- [ ] Unlimited flexibility in monetary policy.
- [x] Vulnerability to speculative attacks.
- [ ] Complete economic independence.
- [ ] Increased volatility in exchange rates.
> **Explanation:** A major risk of a fixed exchange rate is the potential for speculative attacks, particularly if the rate is viewed as unsustainable.
### How does a fixed exchange rate differ from a floating exchange rate?
- [x] A fixed rate is maintained through government policies, whereas a floating rate is determined by the market.
- [ ] A floating rate never changes value while a fixed rate does.
- [ ] Both are maintained purely by market forces.
- [ ] A fixed rate is always higher than a floating rate.
> **Explanation:** Fixed exchange rates are maintained through government intervention, while floating rates are determined by the market without direct government control.
### Which of the following currencies was historically pegged to gold?
- [x] US Dollar
- [ ] Japanese Yen
- [ ] British Pound
- [ ] Chinese Yuan
> **Explanation:** Historically, the US dollar was pegged to gold, particularly during the Bretton Woods system.
### What is meant by 'foreign exchange reserves' in the context of fixed exchange rates?
- [ ] A stockpile of foreign products for trade.
- [ ] Collection of local currency for emergencies.
- [x] Assets held by a central bank in foreign currencies to maintain a fixed exchange rate.
- [ ] Reserves of precious metals like gold and silver.
> **Explanation:** Foreign exchange reserves are critical assets held by a central bank in various foreign currencies used to stabilize and maintain a fixed exchange rate.
### Who typically decides to implement a fixed exchange rate policy?
- [ ] Local private banks.
- [x] National government and central bank authorities.
- [ ] International corporations.
- [ ] Customs and trade authorities.
> **Explanation:** The decision to adopt and maintain a fixed exchange rate is typically made by national government and central bank authorities.
### What is one advantage of a fixed exchange rate for international businesses?
- [x] Predictable exchange rates make planning and budgeting simpler.
- [ ] Instant currency conversion profits.
- [ ] Freedom from government intervention.
- [ ] Guaranteed higher returns on investment.
> **Explanation:** Fixed exchange rates provide stability and predictability, facilitating easier planning and budgeting for international businesses.
### What could cause a fixed exchange rate policy to fail?
- [ ] Excessive foreign exchange reserves.
- [x] Insufficient reserves and economic pressures.
- [ ] Constant government stability.
- [ ] Surplus balances of trade.
> **Explanation:** A fixed exchange rate policy can fail if a country lacks sufficient foreign reserves to maintain the peg, or faces overwhelming economic pressures that make the rate unsustainable.
Thank you for exploring the intricacies of the fixed exchange rate system through our comprehensive guide and quiz. Keep advancing your financial acumen!
