FIXED EXCHANGE RATE SYSTEM AND ITS PROS AND CONS

DEFINITION :A fixed exchange rate is an exchange rate system in which one

currencys value is matched against another currencys value. Fixed exchange
rates are used to pinpoint the value of one currency compared to another so that
trade, investments and other transactions between two countries are easier to
prepare and complete. Fixed exchange rates can also provide greater certainty
for exporters and importers. A system whereby the exchange rates of the
member countries were fixed against the U.S. dollar, with the dollar in turn
worth a fixed amount of gold. Governments try to keep the value of their
currencies constant against one another. A countrys government decides the
worth of its currency in terms of either a fixed weight of gold, a fixed amount of
another currency or a basket of other currencies. The central bank of a country
remains committed at all times to buy and sell its currency at a fixed price. The
central bank provides foreign currency needed to finance payments imbalances.

A fixed exchange rate is a country's exchange rate regime under which

the government or central bank ties the official exchange rate to another
country's currency (or the price of gold). The purpose of a fixed exchange rate
system is to maintain a country's currency value within a very narrow band.
Also known as pegged exchange rate.
In order to maintain this fixed exchange rate, the central bank must maintain a
high level of currency reserves.

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The existence and argument for these types of fixed rates is that the fixed
exchange rate facilitates trade and investment between the two countries with
the pegged currencies. It can be especially beneficial for the smaller country,
which depends more heavily on international trade.
A fixed exchange rate also has its weaknesses; once pegged to a larger countrys
currency, the smaller country can lose some control over its domestic monetary
policy.
HISTORY:
In 1821-1914 Most of the Worlds currencies were redeemable into gold. (i.e.
you could "cash in" your paper notes for predefined weights of gold
coin).Britain was the first to officially adopt this system in 1821 and was
followed by other key countries during 1870s. The result was a global economy
connected by the common use of gold as money. Close to the end of World War
II, the Bretton Woods Agreement was signed. Since the impact of the Great
Depression was still fresh in the minds of the policymakers, they wanted to shun
all possibilities of a similar fiasco. The Bretton Woods Agreement founded a
system of fixed exchange rates in which the currencies of all countries were
pegged to the US dollar, which in turn was based on the gold standard. By 1970,
the existing exchange rate system was already under threat. The Nixon-led US
government suspended the convertibility of the national currency into gold. The
supply of the US dollar had exceeded its demand. In 1971, the Smithsonian
Agreement was signed. For the first time in exchange rate history, the market
forces of supply and demand began to determine the exchange rate.

Flexible Exchange Rate Systems:

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The value of the currency is determined by the market.

Ex: By the interactions of thousands of banks, firms and other institutions
seeking to buy and sell currency for purposes of transactions clearing, hedging,
arbitrage and speculation. So higher demand for a currency, all else equal,
would lead to an appreciation of the currency. Lower demand, all else equal,
would lead to a depreciation of the currency. An increase in the supply of a
currency, all else equal, will lead to a depreciation of that currency while a
decrease in supply, all else equal, will lead to an appreciation. Most OECD
countries have flexible exchange rate systems: the U.S., Canada, Australia,
Britain, and the European Monetary Union.
Managed Floating:
A floating exchange rate in which a government intervenes at
some frequency to change the direction of the float by buying or selling
currencies. Often, the local government makes this intervention, but this is not
always the case. For example, in 1994, the American government bought large
quantities of Mexican pesos to stop the rapid loss of the pesos value. The central
bank does not have an explicit set value for the currency; it also doesnt allow
the market to freely determine the value of the currency.
Example: Suppose that Thailand had a managed floating rate system and that
the Thai central bank wants to keep the value of the Baht close to 25 Baht/$. In
a managed floating regime, the Thai central bank is willing to tolerate small
fluctuations in the exchange rate (say from 24.75 to 25.25) without getting
involved in the market1.
1 http://www.imf.org/external/np/mfd/er/2004/eng.

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Exchange Arrangements with No Separate Legal Tender :

The currency of another country circulates as the sole legal tender (formal
dollarization) the member belongs to a monetary or currency union in which
the same legal tender is shared by the members of the union. It implies the
complete surrender of the monetary authorities independent control over
domestic monetary policy.
Currency Board Arrangements:
Based on an explicit legislative commitment to exchange domestic currency
for a specified foreign currency at a fixed exchange rate, combined with
restrictions on the issuing authority to ensure the fulfillment of its legal
obligation. Domestic currency will be issued only against foreign exchange
and that it remains fully backed by foreign assets, eliminating traditional
central bank functions, such as monetary control and lender-of-last-resort,
and leaving little scope for discretionary monetary policy. Some flexibility
may still be afforded, depending on how strict the banking rules of the
currency board arrangement.
Other Conventional Fixed Peg Arrangements:
The country (formally or de facto) pegs its currency at a fixed rate to
another currency or a basket of currencies, where the basket is formed from
the currencies of major trading or financial partners and weights reflect the
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geographical distribution of trade, services, or capital flows. The currency

composites can also be standardized, as in the case of the SDR. There is no
commitment to keep the parity irrevocably. The exchange rate may fluctuate
within narrow margins of less than 1 percent around a central rate-or the
maximum and minimum value of the exchange rate may remain within a
narrow margin of 2 percent-for at least three months. The monetary authority
stands ready to maintain the fixed parity through direct intervention (i.e., via
sale/purchase of foreign exchange in the market) or indirect intervention
(e.g., via aggressive use of interest rate policy, imposition of foreign
exchange regulations, exercise of moral suasion that constrains foreign
exchange activity, or through intervention by other public institutions).
Flexibility of monetary policy, though limited, is greater than in the case of
exchange arrangements with no separate legal tender and currency boards
because traditional central banking functions are still possible, and the
monetary authority can adjust the level of the exchange rate, although
relatively infrequently.
Pegged Exchange Rates within Horizontal Bands:
The value of the currency is maintained within certain margins of
fluctuation of at least 1 percent around a fixed central rate or the margin
between the maximum and minimum value of the exchange rate exceeds 2
percent. It also includes arrangements of countries in the exchange rate
mechanism (ERM) of the European Monetary System (EMS) that was
replaced with the ERM II on January 1, 1999. There is a limited degree of
monetary policy discretion, depending on the band width.
Crawling Pegs:

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The currency is adjusted periodically in small amounts at a fixed rate or

in response to changes in selective quantitative indicators, such as past
inflation differentials major trading partners, differentials between the
inflation target and expected inflation in major trading partners, and so
forth. The rate of crawl can be set to generate inflation-adjusted changes
in the exchange rate (backward looking), or set at a preannounced fixed
rate and/or below the projected inflation differentials (forward looking).
Maintaining a crawling peg imposes constraints on monetary policy in a
manner similar to a fixed peg system.
Exchange Rates within Crawling Bands:
The currency is maintained within certain fluctuation margins of at least
1 percent around a central rate-or the margin between the maximum and
minimum value of the exchange rate exceeds 2 percent-and the central
rate or margins are adjusted periodically at a fixed rate or in response to
changes in selective quantitative indicators. The degree of exchange rate
flexibility is a function of the band width. Bands are either symmetric
around a crawling central parity or widen gradually with an asymmetric
choice of the crawl of upper and lower bands (in the latter case, there may
be no preannounced central rate). The commitment to maintain the
exchange rate within the band imposes constraints on monetary policy,
with the degree of policy independence being a function of the band
width.
Managed Floating with No Predetermined Path forthe Exchange
Rate:

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The monetary authority attempts to influence the exchange rate without

having a specific exchange rate path or target. Indicators for managing
the rate are broadly judgmental (e.g., balance of payments position,
international reserves, parallel market developments), and adjustments
may not be automatic. Intervention may be direct or indirect.
Independently FloatingThe exchange rate is market-determined,
with any official foreign exchange market intervention aimed at
moderating the rate of change and preventing undue fluctuations in the
exchange rate, rather than at establishing a level for it. 15
SEMI FIXED EXCHANGE RATE:-

This occurs when the government seeks to keep the value of a currency between
a band of exchange rate. In other words, the exchange rate can fluctuate within a
narrow band .
Example; Exchange rate mechanism (ERM) that was a semi fixed exchange
rate where EU countries sought to keep their currencies fixed within certain
bands against the D-mark .The ERM was the forerunner of the Euro.

BRETTON WOODS SYSTEM:One of the important system in fixed exchange rate system is that Bretton
woods system.
After world war II , governments were determined to replace the gold
standard with a more flexible system.They set up the Bretton woods system ,
which was a system with fixed exchange rates. The innovation here was that
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exchange rates were fixed but adjustable.When one currency got too far out of
line with its appropriate or fundamental value , the parity could be adjusted.
The Bretton woods system functioned effectively for the quartercentury after World War II. The system eventually broke down when the dollar
became overvalued. The United States abandoned the Bretton woods system in
1973, and the world moved in to the modern era.

INTERVENTION: -

When a government fixes its exchange rate, it must intervene in

foreign exchange markets to maintain the rate. Government exchange-rate
intervention occurs when the government buys or sells foreign exchange to
affect exchange rates.
Example:
The Japanese government on a given day might buy$1 billion worth of
Japanese yen with U.S.dollars. This would cause a rise in value, or an
appreciation, of the yen.

Fixed exchange rates in accounting:-

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Similarly, companies that work internationally and deal in different currencies

regularly can set fixed exchange rates for their base currency matched against
the foreign currency they work with.Setting a fixed exchange rate in
your accounting system.
For example:
one entire month can make things easier for companies since the
exchange rate will be fixed - as opposed to changing every day. At the end of
e.g. one month, the company can adjust for the currency fluctuation in their
accounts.
Typically, companies can choose the fixed exchange rate as the average
exchange rate from the previous month.

Types of fixed exchange rate systems

The gold standard:-

Under the gold standard, a countrys government declares that it will exchange
its currency for a certain weight in gold. In a pure gold standard, a countrys
government declares that it will freely exchange currency for actual gold at the
designated exchange rate. This "rule of exchange allows anyone to go the
central bank and exchange coins or currency for pure gold or vice versa. The
gold standard works on the assumption that there are no restrictions on capital
movements or export of gold by private citizens across countries.
Because the central bank must always be prepared to give out gold in exchange
for coin and currency upon demand, it must maintain gold reserves. Thus, this
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system ensures that the exchange rate between currencies remains fixed. For
example, under this standard, a 1 gold coin in the United Kingdom contained
113.0016 grains of pure gold, while a $1 gold coin in the United States
contained 23.22 grains

Price specie flow mechanism:The automatic adjustment mechanism under the gold standard is the price
specie flow mechanism, which operates so as to correct any balance of
payments disequilibrium and adjust to shocks or changes. This mechanism was
originally introduced by Richard Cantillon and later discussed by David
Hume in 1752 to refute the mercantilist doctrines and emphasize that nations
could not continuously accumulate gold by exporting more than their imports.

The assumptions of this mechanism are:1. Prices are exible

2. All transactions take place in gold
3. There is a xed supply of gold in the world
4. Gold coins are minted at a xed parity in each country
5. There are no banks and no capital ows

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Reserve currency standard:-

In a reserve currency system, the currency of another country performs the

functions that gold has in a gold standard. A country fixes its own currency
value to a unit of another countrys currency, generally a currency that is
2

prominently used in international transactions or is the currency of a major

trading partner. For example, suppose India decided to fix its currency to the
dollar at the exchange rate E/$ = 45.0. To maintain this fixed exchange rate,
the Reserve Bank of India would need to hold dollars on reserve and stand
ready to exchange rupees for dollars (or dollars for rupees) on demand at the
specified exchange rate. In the gold standard the central bank held gold to
exchange for its own currency, with a reserve currency standard it must hold a
stock of the reserve currency

Gold exchange standard:-

The fixed exchange rate system set up after World War II was a gold-exchange
standard, as was the system that prevailed between 1920 and the early 1930s.
[15]

A gold exchange standard is a mixture of a reserve currency standard and a

gold standard. Its characteristics are as follows:

All non-reserve countries agree to fix their exchange rates to the chosen
reserve at some announced rate and hold a stock of reserve currency assets.

2 http://www.goldmoney.com/gold-research/alasdair- macleod/a-history-of-exchange-rate-

systems.
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The reserve currency country fixes its currency value to a fixed weight in
gold and agrees to exchange on demand its own currency for gold with other
central banks within the system, upon demand.

Advantages of Fixed Exchange Rates:-

1. Avoid Currency Fluctuations. If the value of currencies fluctuate

significantly this can cause problems for firms engaged in trade.

For example if a firm is exporting to the US, a rapid appreciation in

sterling would make its exports uncompetitive and therefore may go out of
business.

If a firm relied on imported raw materials a devaluation would increase

the costs of imports and would reduce profitability
2. Stability encourages investment. The uncertainty of exchange rate
fluctuations can reduce the incentive for firms to invest in export capacity.
Some Japanese firms have said that the UKs reluctance to join the Euro and
provide a stable exchange rates maker the UK a less desirable place to invest.

3. Keep inflation Low. Governments who allow their exchange rate to devalue
may cause inflationary pressures to occur. This is because AD increases, import
prices increase and firms have less incentive to cut costs.
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4. A rapid appreciation in the exchange rate will badly effect manufacturing

firms who export, this may also cause a worsening of the current account.
5. Joining a fixed exchange rate may cause inflationary expectations to be lower

Disadvantage of Fixed Exchange Rates:-

1. Conflict with other objectives. To maintain a fixed level of the exchange

rate may conflict with other macroeconomic objectives.
If a currency is falling below its band the government will have to intervene. It
can do this by buying sterling but this is only a short term measure.
The most effective way to increase the value of a currency is to raise interest
rates. This will increase hot money flows and also reduce inflationary pressures.
However higher interest rates will cause lower AD and economic growth, if
the economy is growing slowly this may cause a recession and rising
unemployment
2. Less Flexibility. It is difficult to respond to temporary shocks. For example
an oil importer may face a balance of payments deficit if oil price increases, but
in a fixed exchange rate there is little chance to devalue.
3. Join at the Wrong Rate. It is difficult to know the right rate to join at. If the
rate is too high, it will make exports uncompetitive. If it is too low, it could
cause inflation.
4. Current Account Imbalances. Fixed exchange rates can lead to current
account imbalances. For example, an overvalued exchange rate could cause a
current account deficit.

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References: Akila Weerapana, Exchange Rate Systems Michael D. Bordo,

Josef Christl and Christian Just, harold James, Exchange Rate Regimes Past,
Present and Future0604.. 16

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BY
J.RAM VIGNESH
BA0140047

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