Fixed exchange rate system

{{Short description|Exchange rate regime where a currency's value is fixed against another value}} {{Multiple issues|{{More citations needed|date=April 2023}} {{Unbalanced|date=August 2023}} }} {{Foreign Exchange}} A '''fixed exchange rate''', often called a '''pegged exchange rate''' or '''pegging''', is a type of [[exchange rate regime]] in which a [[currency]]'s value is fixed, or pegged, by a [[monetary authority]] against the value of another currency, a [[currency basket|basket of other currencies]], or another measure of value, such as [[gold standard|gold]] or [[silver standard|silver]].

There are benefits and risks to using a fixed exchange rate system. A fixed exchange rate is typically used to stabilize the exchange rate of a currency by directly fixing its value in a predetermined ratio to a different, more stable, or more internationally prevalent currency (or currencies) to which the currency is pegged. In doing so, the exchange rate between the currency and its peg does not change based on market conditions, unlike in a [[floating exchange rate|floating (flexible) exchange regime]]. This makes trade and investments between the two currency areas easier and more predictable and is especially useful for small economies that borrow primarily in foreign currency and in which external trade forms a large part of their [[GDP]].

A fixed exchange rate system can also be used to control the behavior of a currency, such as by limiting rates of [[inflation]]. However, in doing so, the pegged currency is then controlled by its reference value. As such, when the reference value rises or falls, it then follows that the values of any currencies pegged to it will also rise and fall in relation to other currencies and commodities with which the pegged currency can be traded. In other words, a pegged currency is dependent on its reference value to dictate how its current worth is defined at any given time. In addition, according to the [[Mundell–Fleming model]], with perfect [[capital (economics)|capital]] mobility, a fixed exchange rate prevents a government from using domestic [[monetary policy]] to achieve [[macroeconomics|macroeconomic]] stability.

In a fixed exchange rate system, a country's [[central bank]] typically uses an open market mechanism and is committed at all times to buy and sell its currency at a fixed price in order to maintain its pegged ratio and, hence, the stable value of its currency in relation to the reference to which it is pegged. To maintain a desired exchange rate, the central bank, during a time of private sector net demand for the foreign currency, sells foreign currency from its reserves and buys back the domestic money. This creates an artificial [[Supply and demand|demand]] for the domestic money, which increases its exchange rate value. Conversely, in the case of an incipient appreciation of the domestic money, the central bank buys back the foreign money and thus adds domestic money into the market, thereby maintaining market equilibrium at the intended fixed value of the exchange rate.<ref name="DBF" />

In the 21st century, the currencies associated with large economies typically do not fix (peg) their exchange rates to other currencies. The last large economy to use a fixed exchange rate system was the [[People's Republic of China]], which, in July 2005, adopted a slightly more flexible exchange rate system, called a [[managed float regime|managed exchange rate]].<ref>{{cite news |url=https://www.washingtonpost.com/wp-dyn/content/article/2005/07/21/AR2005072100351.html |title=China Ends Fixed-Rate Currency |newspaper=[[The Washington Post]] |date=2005-07-22 |first=Peter S. |last=Goodman |access-date=2010-05-06 |archive-date=2017-07-04 |archive-url=https://web.archive.org/web/20170704165428/http://www.washingtonpost.com/wp-dyn/content/article/2005/07/21/AR2005072100351.html |url-status=live }}</ref> The [[European Exchange Rate Mechanism]] is also used on a temporary basis to establish a final conversion rate against the [[euro]] from the local currencies of countries joining the [[Eurozone]].<ref>Cohen, Benjamin J, "Bretton Woods System", ''Routledge Encyclopedia of International Political Economy''</ref><ref>White, Lawrence. ''Is the Gold Standard Still the Gold Standard among Monetary Systems?'', CATO Institute Briefing Paper no. 100, 8 Feb 2008</ref><ref>{{Cite journal| doi = 10.1111/j.1468-0106.2009.00453.x| title = Bretton Woods Ii Still Defines the International Monetary System| year = 2009| last1 = Dooley| first1 = M.| last2 = Folkerts-Landau| first2 = D.| last3 = Garber| first3 = P.| journal = Pacific Economic Review| volume = 14| issue = 3| pages = 297–311| s2cid = 153352827| url = http://www.nber.org/papers/w14731.pdf| doi-access = free| access-date = 2020-09-05| archive-date = 2018-08-20| archive-url = https://web.archive.org/web/20180820185451/http://www.nber.org/papers/w14731.pdf| url-status = live}}</ref>

==History== {{main article|International monetary systems}}

===Chronology=== Timeline of the fixed exchange rate system:<ref name="DS" />

{| class="wikitable" |- | 1880–1914 | Classical gold standard period |- | April 1925 | United Kingdom returns to gold standard |- | October 1929 | [[Great Depression in the United States|United States stock market crashes]] |- | September 1931 | United Kingdom abandons gold standard |- | July 1944 | [[Bretton Woods Conference]] |- | March 1947 | [[International Monetary Fund]] comes into being |- | August 1971 | United States [[Nixon Shock|suspends convertibility]] of dollar into gold – Bretton Woods system collapses |- | December 1971 | [[Smithsonian Agreement]] |- | March 1972 | [[Snake in the tunnel|European snake]] with 2.25% band of fluctuation allowed |- | March 1973 | [[Managed float regime]] comes into being |- | April 1978 | [[Jamaica Accords]] take effect |- | September 1985 | [[Plaza Accord]] |- | September 1992 | United Kingdom and [[Italy]] abandon [[European Monetary System]] (EMS) |- | August 1993 | [[European Monetary System]] allows ±15% fluctuation in exchange rates |}

===Gold standard=== {{Main article|Gold standard}} The gold standard is a monetary system in which a country's currency or paper money has a value directly linked to gold. With the gold standard, countries agreed to convert paper money into a fixed amount of gold upon demand.

===Bretton Woods system=== {{Main article|Bretton Woods system}} The Bretton Woods System is a set of unified rules and policies that provided the framework necessary to create fixed international currency exchange rates. Essentially, the agreement called for the newly created IMF to determine the fixed rate of exchange for currencies around the world

===Current monetary regimes=== A current monetary system is a system by which a government provides money in a country's economy. Modern monetary systems usually consist of the national treasury, the mint, the central banks and commercial banks.

==Mechanisms==

===Open market trading=== Typically, a government wanting to maintain a fixed exchange rate does so by either buying or selling its own currency on the open market.<ref>{{Cite book|title=Economics for the IB Diploma|last=Ellie.|first=Tragakes|date=2012|publisher=Cambridge University Press|isbn=9780521186407|edition=2nd|location=Cambridge|pages=388|oclc=778243977}}</ref> This is one reason governments maintain reserves of foreign currencies.

If the exchange rate drifts too far above the fixed benchmark rate (it is stronger than required), the government sells its own currency (which increases supply) and buys foreign currency. This causes the price of the currency to decrease in value (Read: Classical Demand-Supply diagrams). Also, if they buy the currency it is pegged to, then the price of that currency will increase, causing the relative value of the currencies to approach what is intended.

If the exchange rate drifts too far below the desired rate, the government buys its own currency in the market by selling its reserves. This places greater demand on the market and causes the local currency to become stronger, hopefully back to its intended value. The reserves they sell may be the currency it is pegged to, in which case the value of that currency will fall.

===Fiat=== Another, less used means of maintaining a fixed exchange rate is by simply making it illegal to trade currency at any other rate. This is difficult to enforce and often leads to a [[black market]] in foreign currency. Nonetheless, some countries are highly successful at using this method due to government monopolies over all money conversion. This was the method employed by the Chinese government to maintain a currency peg or tightly banded float against the US dollar. China buys an average of one billion US dollars a day to maintain the currency peg.<ref>{{cite web|url=http://www.forexwatchdog.us/p/chinese-exchange-rate.html|title=The Chinese Exchange Rate and Its Impact On The US Dollar|publisher=ForexWatchDog|author=Cannon, M.|date=September 2016|access-date=2016-10-04|archive-date=2017-12-03|archive-url=https://web.archive.org/web/20171203060747/http://www.forexwatchdog.us/p/chinese-exchange-rate.html|url-status=dead}}</ref> Throughout the 1990s, China was highly successful at maintaining a currency peg using a government monopoly over all currency conversion between the yuan and other currencies.<ref>{{cite news |url=https://www.washingtonpost.com/wp-dyn/content/article/2005/07/26/AR2005072600681.html |title=Don't Expect Yuan To Rise Much, China Tells World |newspaper=[[The Washington Post]] |date=2005-07-27 |first=Peter S. |last=Goodman |access-date=2010-05-06 |archive-date=2023-03-27 |archive-url=https://web.archive.org/web/20230327050848/https://www.washingtonpost.com/wp-dyn/content/article/2005/07/26/AR2005072600681.html |url-status=live }}</ref><ref>{{cite web |url=http://www.cato.org/pub_display.php?pub_id=3946 |title=Protectionism No Fix for China's Currency |first=Daniel |last=Griswold |publisher=Cato Institute |date=2005-06-25 |access-date=2010-05-06 |archive-date=2023-02-03 |archive-url=https://web.archive.org/web/20230203003317/https://www.cato.org/pub_display.php?pub_id=3946 |url-status=live }}</ref><ref>{{Cite journal | last1 = O'Connell | first1 = Joan | year = 1968 | title = An International Adjustment Mechanism with Fixed Exchange Rates | journal = Economica | volume = 35 | issue = 139 | pages = 274–282 | jstor = 2552303 | doi = 10.2307/2552303 }}</ref>

===Excess demand for dollars=== [[File:Excess Demand for Dollars.png|thumb|right|100px|alt=|Fig.2: Excess demand for dollars]] {{Expand section|date=July 2023}}

===Excess supply of dollars=== [[File:Excess Supply of Dollars.png|thumb|right|100px|alt=|Fig.3: Excess supply of dollars]] {{Expand section|date=July 2023}}

==Types of fixed exchange rate systems==

===The gold standard=== {{main|Gold standard}}{{Expand section|date=March 2024}} The gold standard is the pegging of money to a certain amount of gold.

===Price specie flow mechanism=== {{Expand section|date=July 2023}}

===Reserve currency standard===

[[Currency board]] arrangements are the most widespread means of fixed exchange rates. Currency boards are considered hard pegs as they allow central banks to cope with shocks to money demand without running out of reserves.<ref name=":0">{{Cite book|last1=Feenstra|first1=Robert C.|title=International Macroeconomics|last2=Taylor|first2=Alan M.|publisher=Worth|year=2012|isbn=978-1429241038|location=New York}}</ref> CBAs have been operational in many nations including: *[[Hong Kong Monetary Authority#Currency board system|Hong Kong]] (since 1983); *[[Argentine Currency Board|Argentina]] (1991 to 2001); *[[Estonian kroon#Second kroon, 1992–2010|Estonia]] (1992 to 2010); *[[Lithuanian litas#Second litas, 1993|Lithuania]] (1994 to 2014); *[[Bosnia and Herzegovina convertible mark#History|Bosnia and Herzegovina]] (since 1997); *[[Bulgarian lev#History|Bulgaria]] (1997 to 2025); *[[Bermudian dollar#History|Bermuda]] (since 1972); *[[Danish krone#History|Denmark]] (since 1945){{Citation needed|date=April 2022}}; *[[Brunei dollar#History|Brunei]] (since 1967)<ref>Salvatore, Dominick; Dean, J; Willett, T. ''The Dollarisation Debate'' (Oxford University Press, 2003)</ref><ref>{{Cite journal| doi = 10.1016/S0261-5606(02)00074-8| title = The inter-war gold exchange standard: Credibility and monetary independence| year = 2003| last1 = Bordo| first1 = M. D.| last2 = MacDonald| first2 = R.| journal = Journal of International Money and Finance| volume = 22| pages = 1–32| s2cid = 154706279| url = http://www.nber.org/papers/w8429.pdf| access-date = 2019-12-11| archive-date = 2018-06-02| archive-url = https://web.archive.org/web/20180602062829/http://www.nber.org/papers/w8429.pdf| url-status = live}}</ref>

===Gold exchange standard=== {{Expand section|date=July 2023}}

==Hybrid exchange rate systems==

[[Image:Exchange rate arrangements map.svg|thumb| ''De facto'' exchange-rate arrangements in 2023 as classified by the [[International Monetary Fund]]. {{Legend|#66c2a5|[[floating exchange rate|Floating]] (''floating'' and ''free floating'')}} {{Legend|#8da0cb|Soft pegs (''[[fixed exchange rate|conventional peg]]'', ''stabilized arrangement'', ''[[crawling peg]]'', ''crawl-like arrangement'', ''[[currency band|pegged exchange rate within horizontal bands]]'')}} {{Legend|#fc8d62|Hard pegs (''[[currency substitution|no separate legal tender]]'', ''[[currency board]]'')}} {{Legend|#e78ac3|Residual (''other managed arrangement'')}} |alt=]]

===Basket-of-currencies=== {{Expand section|date=July 2023}}

===Crawling pegs=== {{Main article|Crawling peg}}

===Pegged within a band=== {{Expand section|date=July 2023}}

===Currency boards=== {{Expand section|date=July 2023}}

===Currency substitution=== {{Expand section|date=July 2023}}

===Monetary co-operation=== Monetary co-operation is the mechanism in which two or more [[monetary policies]] or [[exchange rates]] are linked, and can happen at regional or international level.<ref>Bergsten, C. F., & Green, R. A. (2016). Overview International Monetary Cooperation: Peterson Institute for International Economics</ref> The monetary co-operation does not necessarily need to be a voluntary arrangement between two countries, as it is also possible for a country to link its [[currency]] to another countries currency without the [[consent]] of the other country. Various forms of monetary co-operations exist, which range from fixed parity systems to [[currency union|monetary unions]]. Also, numerous institutions have been established to enforce monetary co-operation and to stabilise [[exchange rate]]s, including the [[European Monetary Cooperation Fund]] (EMCF) in 1973<ref>[[European Monetary Cooperation Fund|European Monetary Cooperation Fund on Wikipedia]]</ref> and the [[International Monetary Fund]] (IMF)<ref>Von Mises, L. (2010). International Monetary Cooperation. Mises Daily Articles. Retrieved from https://mises.org/library/international-monetary-cooperation {{Webarchive|url=https://web.archive.org/web/20231103072022/https://mises.org/library/international-monetary-cooperation |date=2023-11-03 }}</ref>{{Unreliable source?|date=October 2020|certain=y}}

Monetary co-operation is closely related to [[economic integration]], and are often considered to be reinforcing processes.<ref name=Berben03>Berben, R.-P., Berk, J. M., Nitihanprapas, E., Sangsuphan, K., Puapan, P., & Sodsriwiboon, P. (2003). Requirements for successful currency regimes: The Dutch and Thai experiences: De Nederlandsche Bank</ref> However, economic integration is an economic arrangement between different regions, marked by the reduction or elimination of [[trade barriers]] and the coordination of monetary and [[fiscal policies]],<ref>{{Cite web |url=http://www.investopedia.com/terms/e/economic-integration.asp#ixzz4OHYoIkh4 |title=Economic Integration on Investopedia |access-date=2016-12-06 |archive-date=2018-02-01 |archive-url=https://web.archive.org/web/20180201201522/https://www.investopedia.com/terms/e/economic-integration.asp#ixzz4OHYoIkh4 |url-status=live }}</ref> whereas monetary co-operation is focussed on currency linkages. A [[monetary union]] is considered to be the crowning step of a process of monetary co-operation and [[economic integration]].<ref name=Berben03/> In the form of monetary co-operation where two or more countries engage in a mutually beneficial exchange, [[capital (economics)|capital]] among the countries involved is free to move, in contrast to [[capital controls]].<ref name=Berben03 /> Monetary co-operation is considered to promote balanced [[economic growth]] and monetary stability,<ref>James, H. (1996). International monetary cooperation since Bretton Woods: International Monetary Fund</ref> but can also work counter-effectively if the member countries have (strongly) differing levels of [[economic development]].<ref name=Berben03 /> Especially European and Asian countries have a history of monetary and exchange rate co-operation,<ref>Volz, U. (2010). Introduction Prospects for Monetary Cooperation and Integration in East Asia. Cambridge, Massachusetts: MIT Press</ref> however the European monetary co-operation and economic integration eventually resulted in a [[Economic and Monetary Union of the European Union|European monetary union]].

====Example: The Snake==== In 1973, the currencies of the [[European Economic Community]] countries, Belgium, France, Germany, Italy, Luxemburg and the Netherlands, participated in an arrangement called ''the Snake''. This arrangement is categorized as exchange rate co-operation. During the next 6 years, this agreement allowed the currencies of the participating countries to [[Volatility (finance)|fluctuate]] within a band of plus or minus 2¼% around pre-announced [[exchange rate|central rates]]. Later, in 1979, the [[European Monetary System]] (EMS) was founded, with the participating countries in ''‘the Snake’'' being founding members. The EMS evolves over the next decade and even results into a truly [[fixed exchange rate]] at the start of the 1990s.<ref name=Berben03 /> Around this time, in 1990, the [[EU]] introduced the [[Economic and Monetary Union]] (EMU), as an umbrella term for the group of policies aimed at converging the [[economies]] of member states of the [[European Union]] over three phases <ref>[[Economic and Monetary Union of the European Union|Economic and Monetary Union of the European Union on Wikipedia]]</ref>

====Example: The baht-U.S. dollar co-operation==== In 1963, the Thai government established the Exchange Equalization Fund (EEF) with the purpose of playing a role in stabilizing exchange rate movements. It linked to the [[U.S. dollar]] by fixing the amount of gram of [[gold]] per [[baht]] as well as the baht per U.S. dollar. Over the course of the next 15 years, the Thai government decided to [[depreciate]] the baht in terms of gold three times, yet maintain the [[Purchasing power parity|parity]] of the baht against the U.S. dollar. Due to the introduction of a new generalized floating exchange rate system by the [[International Monetary Fund]] (IMF) in 1978 that gave a smaller role to gold in the international monetary system, this fixed parity system as a monetary co-operation policy was terminated. The Thai government amended its monetary policies to be more in line with the new IMF policy.<ref name=Berben03 />

==Fixed exchange rate system advantage==

==Disadvantages==

===Lack of automatic rebalancing=== One main criticism of a fixed exchange rate is that flexible exchange rates serve to adjust the [[balance of trade]].<ref name="suranovic">{{cite book | last = Suranovic | first = Steven | title = International Finance Theory and Policy | publisher = Palgrave Macmillan | date = 2008-02-14 | page = 504 }}</ref> When a trade deficit occurs under a floating exchange rate, there will be increased demand for the foreign (rather than domestic) currency which will push up the price of the foreign currency in terms of the domestic currency. That in turn makes the price of foreign goods less attractive to the domestic market and thus pushes down the trade deficit. Under fixed exchange rates, this automatic rebalancing does not occur.

===Currency crisis=== Another major disadvantage of a fixed exchange-rate regime is the possibility of the central bank running out of foreign exchange reserves when trying to maintain the peg in the face of demand for foreign reserves exceeding their supply. This is called a [[currency crisis]] or balance of payments crisis, and when it happens the central bank must [[devaluation|devalue]] the currency. When there is the prospect of this happening, private-sector agents will try to protect themselves by decreasing their holdings of the domestic currency and increasing their holdings of the foreign currency, which has the effect of increasing the likelihood that the forced devaluation will occur. A forced devaluation will change the exchange rate by more than the day-by-day exchange rate fluctuations under a flexible exchange rate system.

===Freedom to conduct monetary and fiscal policy===

Moreover, a government, when having a fixed rather than dynamic exchange rate, cannot use monetary or fiscal policies with a free hand. For instance, by using reflationary tools to set the economy growing faster (by decreasing taxes and injecting more money in the market), the government risks running into a trade deficit. This might occur as the purchasing power of a common household increases along with inflation, thus making imports relatively cheaper.{{citation needed|date=May 2014}}

Additionally, the stubbornness of a government in defending a fixed exchange rate when in a [[trade deficit]] will force it to use deflationary measures (increased taxation and reduced availability of money), which can lead to [[unemployment]]. Finally, other countries with a fixed exchange rate can also retaliate in response to a certain country using the currency of theirs in defending their exchange rate.{{citation needed|date=May 2014}}

==Fixed exchange rate regime versus capital control== The belief that the '''fixed exchange rate regime''' brings with it stability is only partly true, since [[speculative attack]]s tend to target currencies with fixed exchange rate regimes, and in fact, the stability of the economic system is maintained mainly through [[capital control]]. A fixed exchange rate regime should be viewed as a tool in capital control.{{POV statement|date=May 2014}}{{citation needed|date=May 2014}}

==FIX Line: Trade-off between symmetry of shocks and integration== *The trade-off between symmetry of shocks and market integration for countries contemplating a pegged currency is outlined in Feenstra and Taylor's 2015 publication "International Macroeconomics" through a model known as the FIX Line Diagram. *This symmetry-integration diagram features two regions, divided by a 45-degree line with slope of -1. This line can shift to the left or to the right depending on extra costs or benefits of floating. The line has slope= -1 is because the larger symmetry benefits are, the less pronounced integration benefits have to be and vice versa. The right region contains countries that have positive potential for pegging, while the left region contains countries that face significant risks and deterrents to pegging. *This diagram underscores the two main factors that drive a country to contemplate pegging a currency to another, shock symmetry and market integration. Shock symmetry can be characterized as two countries having similar demand shocks due to similar industry breakdowns and economies, while market integration is a factor of the volume of trading that occurs between member nations of the peg. *In extreme cases, it is possible for a country to only exhibit one of these characteristics and still have positive pegging potential. For example, a country that exhibits complete symmetry of shocks but has zero market integration could benefit from fixing a currency. The opposite is true, a country that has zero symmetry of shocks but has maximum trade integration (effectively one market between member countries). *This can be viewed on an international scale as well as a local scale. For example, neighborhoods within a city would experience enormous benefits from a common currency, while poorly integrated and dissimilar countries are likely to face large costs.

==See also== {{Div col|colwidth=20em}} *[[List of circulating fixed exchange rate currencies]] *[[Exchange rate regime]] *[[Floating exchange rate]] *[[Linked exchange rate]] *[[Managed float regime]] *[[Gold standard]] *[[Bretton Woods system]] *[[Nixon shock]] *[[Smithsonian Agreement]] *[[Foreign exchange fixing]] *[[Currency union]] *[[Black Wednesday]] *[[Capital control]] *[[Convertibility]] *[[Currency board]] *[[Impossible trinity]] *[[Speculative attack]] *[[Swan diagram]] {{div col end}}

==References== {{Reflist|30em|refs=

<ref name="DBF">{{cite book |last1=Dornbusch |first1=Rüdiger |author-link=Rüdiger Dornbusch |last2=Fisher |first2=Stanley |author2-link=Stanley Fischer |last3=Startz |first3=Richard |title=Macroeconomics |edition=Eleventh |publisher=McGraw-Hill/Irwin |location=New York |year=2011 |isbn=978-0-07-337592-2}}</ref>

<ref name="DS">{{cite book|last=Salvatore|first=Dominick|title=International Economics|publisher=John Wiley & Sons|year=2004|isbn=978-81-265-1413-7}}</ref>

<!---ref name="KM">{{cite book|last=Kreinin|first=Mordechai|author-link=Mordechai E. Kreinin|title=International Economics: A Policy Approach|publisher=Pearson Learning Solutions|year=2010|isbn=978-0-558-58883-0|pages=438}}</ref>

<ref name="CHRO">{{cite book|last1=Bordo|first1=Michael D.|last2=Christl|first2=Josef|last3=Just|first3=Christian|last4=James|first4=Harold|title=OENB Working Paper (no. 92)|year=2004|url=http://www.oenb.at/dms/oenb/Publikationen/Volkswirtschaft/Working-Papers/2004/Working-Paper-92/fullversion/wp92_tcm16-22389.pdf}}</ref>

<ref name="DVH">{{cite book|last=Cooper|first=R.N.|title=International Finance|pages=25–37|publisher=Penguin Publishers|year=1969}}</ref>

<ref name="MDB">{{cite book|last=Bordo|first=Michael|title=Gold Standard and Related Regimes: Collected Essays|year=1999|publisher=Cambridge University Press|isbn=978-0-521-55006-2}}</ref>

<ref name="GS">{{Cite book | last1 = Garber | first1 = Peter M. | last2 = Svensson | first2 = Lars E. O. | year = 1995 | chapter = The Operation and Collapse of Fixed Exchange Rate Regimes | title = Handbook of International Economics | volume = 3 | pages = 1865–1911 | publisher = Elsevier | doi = 10.1016/S1573-4404(05)80016-4 | isbn = 9780444815477 }}</ref--->

}}

[[Category:Foreign exchange market]] [[Category:Gold standard]]

[[fr:Régime de change#Régime de change fixe]]