fixed exchange rate: overview, pros and cons, and examples

Why might one country peg its currency to that of another?

Where one currency’s value is tied to the value of:1) that of another currency - e.g., USD/HKD = 7.75001) a basket of currencies to minimize

currency fluctuations- e.g., SDR (composite currency)1) some other measure of value (like gold)

What is a “pegged” exchange rate?

Some basic economic reasonsExports and Trade- Pegging holds attraction to economies seeking export-

driven growthEx. USD/LKR = 133

Helps limit inflation and other instabilities- Moves in step with the reference currency/ies or

commodity/ies to which its pegged- Nations with high inflation rates typically face high

deficits and loss of foreign currency reserves

Helps central banks acquire credibility - patterns currency to that of a more

disciplined/developed nation Reduces uncertainty -- i.e., “exchange rate risk”Facilitate investment flowsFixed/pegged exchange rates diminish the degree of volatility and variation in relative prices

Provide money markets in a nation in whichthese are illiquid, undeveloped, and otherwise unviable

Money market elaboration1) Facilitates industry- provides short-term loans1) Helps trade w/ commercial finance available2) Good for central banks- money markets provide short-term interest rates1) Self-sufficiency of commercial banks- paucity of funds, can recall loans1) Allows commercial banks to be financially successful- excess bank reserves converted into bills of exchange

Economic Disadvantages

Enables trade deficits- under a floating rate system this automatically balancesEconomics of trade deficit rebalancing- demand for foreign currency ↑- price of foreign currency ↑- in turn, foreign goods less appealing to domestic market- trade deficit thereby diminishes

Disadvantages

Limits the ability to use monetary and fiscal policy at liberty- stimulatory efforts typically decrease trade balancesTo close a trade deficit, deflationary measures may be utilized- can lead to negative economic outcomes like

unemployment

Disadvantages

Floating exchange rates may help to determine CA between nations- has implications for efficient resource allocationBroader array of sophisticated modern financial instruments may render exchange rate pegging unnecessaryForex markets may not operate as efficiently as they would otherwise due to government intervention efforts

Disadvantages

Desired exchange rate may not coincide with the equilibrium exchange rate- leads to excess supply or demand of a currencyIn order to peg exchange rates, reserve currencies are needed to absorb any excess supply or demand

How are exchanged rates fixed?

Open market trading- Buying/selling its currency on the open market- For a currency to appreciate, it will buy its own currency

using its foreign currency reserves (increase demand)- For a currency to depreciate, it will sell its own currency

and buy foreign currency (decrease demand)- To avoid inflation/deflation as a result of money supply

fluctuation, gov’t bonds may be sold/purchased

How are exchanged rates fixed?

Through fiat (legal decree)- unpopular due to the threat of black market activity- can be used effectively with government monopolies

designed to govern currency conversion

Notable Int’l Examples of Pegging- European Union (EU)- Denmark (through ERM II), Bosnia and Herzegovina

(Deutschmark), Bulgaria (Deutschmark)- Switzerland (tied to Euro until January 2015)- China yuan to USD- Ecuador, El Salvador, Panama (dollarization)

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