Fixed Exchange Rate

What Is Fixed Exchange Rate?

A fixed exchange rate refers to an exchange rate regime where a country's currency value will be tied to the value of another country's currency or a major commodity. Having a fixed regime helps the country create a stable environment for international trade. A fixed exchange rate regime helps importers and exporters to have more certainty and helps governments maintain low inflation.

The other common options of exchange rate regimes are floating exchange rates and pegged float exchange rates. When fixed regime values are set by the government or central bank of a country, the floating exchange rate is determined by the supply and demand forces in the foreign exchange market. It gained prominence in the early 1970s among industrialized nations of the world.

• The fixed exchange rate refers to an exchange rate regime followed by countries whose currency is anchored to another country’s currency or a valuable commodity like gold.
• The system helps control inflation, exchange rate certainty, and a stable environment for facilitating international trade.
• Qatar is an example of a country following a fixed regime. 1 United States Dollar equals 3.64 Qatari Rial.
• The opposite concept is the floating exchange rate system, where the value of a country’s currency is determined by the supply and demand forces relative to other currencies in the forex market.

How Fixed Exchange Rate Work?

A fixed exchange rate definition explains that people can always exchange their money in one currency for a predefined amount in another currency. It's the choice of the monetary authority of a country to choose from different exchange rate regimes. They make decisions by considering several factors like GDP, political stability, reserves, and vulnerability to inflation.

The popularization of the fixed exchange rate system is traced back to World War II. In the past, specifically during the 19th-century, bimetallism was widely used, followed by the gold standard or gold exchange standard of fixed exchange rates. In 1944 with the Bretton Woods Agreement, most countries collectively connected their respective currencies to the U.S. dollar. The United States government welcomed the agreement and decided to redeem all dollars for gold. By the late 20th century, the world witnessed the collapse of the system and the growing acceptance of the floating exchange rate system.

The contrasting concept of a fixed exchange rate graph is the floating exchange regime, where the currency value fluctuates based on the forex market events. Nowadays, most countries use a floating exchange rate system since it represents the value of currency more fairly. For example, under the floating system, if one U.S. dollar is equal to 74.64 INR today, the very next day, one USD can be equal to 75.41 INR. In contrast, one USD is always around 3.67 UAE Dirhams reflecting the fixed exchange regime.

Examples

Now that we have an understanding of the basics of the fixed exchange rate regime and its related factors, let us now apply this theoretical knowledge to practical application through the examples below.

Example #1

The financial crisis in 2019 resulted in an intense drop in Lebanese pound value. In the parallel market (black market) exchange rate reached a level of 23,000 in January 2021, even if the official exchange rate remains at 1,507.5 pounds per dollar. There is news that Lebanon's draft budget for 2022 will project exchange rates ranging between 15,000 and 20,000 Lebanese pounds per dollar for operating expenses, planning a shift from the previously used official rate of around 1,500.

Furthermore, a retrospective of 2020 reflects that in July, the central bank of Lebanon announced that it would provide foreign currency at a fixed exchange rate of 3,900 Lebanese pounds per dollar for manufacturers and importers of essential food items. Therefore, the Lebanese central bank is advancing towards securing the necessary amounts of foreign currency to ensure the needs of stakeholders like manufacturers and importers of essential food items and inputs used in food industries. 

Example #2

Egypt is one of the oldest established countries in the world. However, their trade and economy have been struggling to multiply and grow at a pace that experts once claimed it to grow. In January 2023, the International Monetary Fund (IMF) encouraged Egypt to take up its advice to permanently shift to a flexible exchange rate to ensure their reserves can be renewed and imbalances in their finances can be avoided.

For further context, this advice came after the IMF approves a $3 billion loan for 46 months to Egypt. However, it is important to note that the country has been trying to shift to a flexible regime for years with their trials to do so in 2016 being a testament of the same. The country shall have to make significant changes to the existing fixed exchange rate regime’s norms and laws.

Advantages and Disadvantages

Every regime has its benefits and problems. Let's look into the advantages and disadvantages of a fixed exchange rate regime.

Advantages

• It stabilizes the currency value in foreign markets, and minimizes the uncertainty and risk factors by taking care of any undue fluctuations.
• It remains constant for a long time. Therefore, people believe it will not change shortly, eventually killing its speculations.
• For small countries facing a BOP (balance of payment) crisis, any sudden change in the exchange rate can discourage a lot of business and market activities. 
• It helps avoid the drastic depreciation of the currency, which is pivotal.
• It encourages foreigners to make more investments in a country, taking advantage of a stable exchange rate.
• When a fixed rate of exchange is correctly regulated, it discourages governments from adopting unwanted macroeconomic policies.
• It aids in keeping the prices of goods and services regulated. It ensures that the inflation rate is minimized. A good exchange rate is characterized to be anti-inflationary.

Disadvantages

• Under a fixed exchange regime, the currency cannot gain or devalue in response to the market forces; hence automatic adjustment of imbalances in the nation’s balance of payments will not happen automatically.
• The use of monetary and fiscal policy will not be easy.
• The necessary condition to maintain it is the adequate holding and foreign exchange reserves required. Therefore, it is difficult for small and developing countries.
• Every country has its internal problems to resolve. But unfortunately, many growth-related objectives and internal issues are often sacrificed to maintain and control the fixed exchange regime.

Fixed Exchange Rate Vs Floating Exchange Rate

While both these exchange rates help governments set policies for the exchange of currencies and aid import and export to improve their economies, there are vast differences between these concepts. Let us understand the differences in their fundamentals and implications through the comparison below.

Fixed Exchange Rate

• It is also commonly referred to as a pegged rate. It is set by the central bank of a country and the apex bank of the country is also responsible for the maintenance and regulation of the official rate.
• A base or set price is fixed against a major world currency such as the U.S. dollar or Euro, or a basket of such currencies.
• To maintain the local exchange rate, the central bank trades its own currency on the foreign exchange market in return for the currency it has fixed or pegged.
• It is used as a reserve amount of foreign currency that can be used to absorb or release extra funds into or out of the market.
• The central bank makes adjustments necessary to ensure a proper range of inflation or deflation and a proper flow of cash in the market.

Floating Exchange Rate

• A floating exchange rate is determined by market forces of demand and supply. It is also commonly referred to as a self-correcting rate.
• If the demand for a currency is low, its price in the open market will experience a fall. As a result, the goods and services in the local market shall have a hike in demand as imported goods shall become more expensive.
• To avoid inflation and ensure stability, the central bank of a country might intervene and make necessary changes in a floating regime. However, it is rare for this to occur.
• This system helps economies maintain a lower reserve and allows fiscal bodies to have a greater degree of internal control.

Frequently Asked Questions (FAQs)

Recommended Articles 

This has been a guide to what is Fixed Exchange Rate. We explain its advantages and disadvantages, examples, and compared it with floating exchange rate. You can learn more from the following articles - 

• Exchange Rate Formula
• Exchange Rate Risk
• Currency Pair