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A fixed exchange rate is a monetary policy where a country's currency value is pegged to another currency's value, a basket of currencies, or a precious commodity like gold. This article will take you on a global tour, visiting various countries that operate under a fixed exchange rate system and providing concrete examples of how it works in practice. We'll also weigh the scales of benefits and drawbacks, examining the advantages and disadvantages that this system presents, to deliver a comprehensive understanding of fixed exchange rates.
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Team Fixed Exchange Rate Teachers
There are three different types of exchange rates:
As we said, here we will focus in detail on the fixed exchange rate.
A fixed exchange rate is one where a government sets their currency against another.
When explaining a rise or fall in the value of a fixed exchange rate, we can use these two key terms: revaluation and devaluation.
Revaluation is when a government fixes a new higher exchange rate for a currency in a fixed system.
Devaluation is when a government fixes a new lower exchange rate for a currency in a fixed system.
Check out our Floating Exchange Rate explanation to understand the other two different exchange rates.
Before discussing the example, let’s understand how a fixed exchange rate system works.
When a country opts for a fixed exchange rate, the fixed rate is determined by its central bank. This rate is then pegged to another currency. In this example, we will look at the Zimbabwean dollars and the US dollars.
The ZWL dollar was pegged to the US dollar in March. The fixed exchange rate was $1 USD to $25 ZWL.
This fixed exchange rate is known as the central peg or central rate.
The central bank would have to decide on a currency band. This band specifies the upper and lower limit, called 'ceiling' and 'floor' respectively, for the peg. The currency can now freely float so long as it is within the two bands. This is illustrated in Figure 1 below.
Fig. 1 - Fixed exchange rate
In figure 1, we can see the 'upper limit' and 'lower limit' below and above the central peg. The currency can float in between these two bands without government intervention. Once it floats above or below the limit, the central bank must intervene. The exchange rate must be brought back closer to the central peg. One way they do this is by selling or buying back their currency on the foreign exchange market.
The primary aim of fixing an exchange rate is to create stability and certainty for exporters, importers, investors, and consumers.
This was the Zimbabwean government’s aim when they pegged their currency to the US dollar. However, inflation in Zimbabwe climbed, which had an impact on their exchange rate. Soon the exchange rate was $1 US dollar to $60 ZWL dollars, and they scrapped the fixed exchange rate.
There are many advantages of a fixed exchange rate. Some of these advantages were the main reason for Zimbabwe to adopt this system in the first place.
The advantages are:
A fixed exchange rate has disadvantages too. Some of these are the reason that caused Zimbabwe to scrap the fixed exchange rate.
The disadvantages are:
In a fixed exchange rate system, countries can peg their currency against more than one currency as well.
Some countries which have their currency tied up to the US dollar are:
Countries that have their currencies tied to a basket of foreign currencies instead of a single currency are:
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How is an exchange rate fixed?
The exchange rate can be fixed by either the government or its central bank. They set the rate: the upper and lower limits that the exchange rate can move between. The central bank is responsible for maintaining the exchange rate at the rate decided.
What is floating and fixed exchange rate?
A floating exchange rate is one that is left to float and be determined by the supply and demand of a currency on the foreign exchange market. This means that the government or any other authority doesn’t intervene. A fixed exchange rate is one that is 'fixed' or decided by the government of a country or its central bank.
How is a fixed exchange rate determined?
The fixed exchange rate is determined by the government or the central bank. They fix or peg the rate to another currency (like the US dollar) or a basket of currencies. The central bank is in charge of maintaining the exchange rate at the target rate.
How do governments maintain a fixed exchange rate?
The fixed exchange rate is maintained by the central bank. It ensures that the exchange rate doesn't cross the upper or lower boundaries of the exchange rate band. It can either buy or sell official foreign currency reserves or increase or decrease domestic interest rates, depending on whether the exchange rate has risen higher than the ceiling rate or fallen below the floor rate.
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