What Is a Fixed Exchange Rate and How Does It Work?

An exchange rate represents the value of one nation’s currency when traded for another. These rates are fundamental to international trade and financial transactions, influencing import and export costs and the profitability of foreign investments. A fixed exchange rate system establishes a currency’s value at a predetermined level, tying it to another currency, a group of currencies, or a commodity like gold. This system aims to provide stability in the international financial landscape.

Understanding a Fixed Exchange Rate

A fixed exchange rate, also known as a pegged exchange rate, is a system where a country’s monetary authority officially sets and maintains the value of its currency. The government or central bank publicly commits to this specific exchange rate, ensuring the currency’s value remains within a very narrow band.

The primary objective of a fixed exchange rate system is to foster stability and predictability in international commerce and finance. By removing significant currency fluctuations, businesses engaged in importing or exporting can forecast costs and revenues with greater certainty. This predictability encourages international trade and investment, as participants face reduced currency risk. Unlike floating rates, a currency’s value under a fixed system is not primarily determined by daily market forces of supply and demand. Instead, its value is a policy decision maintained through deliberate central bank actions.

How Fixed Exchange Rates Are Maintained

Maintaining a fixed exchange rate requires active and continuous intervention by a country’s central bank. One primary tool involves foreign exchange reserves. These reserves act as a buffer. When there is downward pressure on the domestic currency, the central bank sells its foreign currency reserves to buy back its own currency in the foreign exchange market. This action increases demand for the domestic currency, supporting its value.

Conversely, if the domestic currency experiences upward pressure and threatens to exceed its pegged value, the central bank intervenes by selling its domestic currency and buying foreign currency. This increases the supply of the domestic currency in the market, which helps to keep it within the established narrow band. The central bank must hold substantial foreign exchange reserves to effectively carry out these interventions. Without adequate reserves, a central bank may struggle to defend its currency peg during periods of significant market pressure.

Interest rate adjustments also play a significant role in defending a fixed exchange rate. A central bank can raise domestic interest rates to attract foreign capital, making it more appealing for foreign investors to hold the domestic currency. Higher interest rates increase demand for the local currency, supporting its value against the peg. Conversely, lowering interest rates can discourage capital inflows or encourage outflows, which can help alleviate upward pressure on the currency.

In some cases, governments may implement capital controls to maintain a fixed exchange rate. These controls involve restrictions on the movement of capital into or out of a country. Such measures can include taxes on certain international asset transactions or mandatory reserve requirements for foreign investments.

Fixed Versus Floating Exchange Rates

The distinction between fixed and floating exchange rate systems lies in how a currency’s value is determined and how it responds to economic shifts. Under a floating exchange rate system, a currency’s value is primarily dictated by supply and demand in the foreign exchange market. These values fluctuate based on various economic factors, including trade balances, interest rate differentials, inflation rates, and overall investor sentiment. In such a system, market mechanisms automatically adjust to economic shocks, with the currency’s value appreciating or depreciating.

In contrast, a fixed exchange rate system operates by governmental or central bank policy that establishes a specific value for its currency relative to another. While floating rates adjust through the currency’s value changing, fixed rates require direct intervention and policy adjustments to maintain their peg. For instance, a country with a floating rate might see its currency depreciate during an economic downturn, which can make its exports cheaper and potentially stimulate economic recovery. This automatic adjustment helps insulate the domestic economy from external shocks.

However, a fixed exchange rate system requires the central bank to intervene regularly in the market to uphold the set rate. This often means sacrificing an independent monetary policy, as interest rates or money supply must be managed to support the peg rather than solely to address domestic economic conditions. Unlike floating systems that self-correct through currency price movements, fixed systems rely on the active management and financial resources of the central bank to absorb or supply currency as needed. The choice between these two systems involves a trade-off between exchange rate stability and monetary policy autonomy.