Fixed exchange rate

economic-dictionary

The fixed exchange rate is an exchange rate in which the government of a country establishes the value of its national currency by associating the value with that of the currency of another country.

In the market, even though the value of the coins is set, the market causes their prices to rise and fall with each other. To establish a fixed exchange rate and prevent the price of the currency from fluctuating, the central bank buys and sells its own currency on the foreign exchange market in exchange for the currency to which it is linked, exerting a strong demand or supply of its currency. own currency, to place the price of your currency at the established fixed exchange rate.

Therefore, in order to maintain fixed exchange rates, the central bank of the linked country must have stored large amounts of the currency to which it is linked in its reserves.

Reasons for establishing a fixed exchange rate

The two main reasons for setting a fixed exchange rate are:

  • The fixed exchange rate is normally established before the instability of a currency, to correct an economy that is not stable, or that depends to a great extent on the value of the currency. These constant changes in the value do not help the economic growth of the country at all, since it makes people lose the confidence of trade and international investors as there is not enough economic security.
  • A fixed exchange rate is also established to reduce the investment risk of citizens and investors (as Switzerland does with the euro for example).
Real exchange rate Flexible exchange rate

Classification of fixed exchange rates

Since maintaining a fixed exchange rate stable over time is costly and inflexible, there are several fixed exchange rate regimes:

  • Convertibility regime or currency board: It is the strictest category of fixed exchange rate. In this case, the exchange rate is established by law. Its rules work in the same way as the gold standard, the central bank is obliged to immediately convert into the linked currency every time a citizen presents cash. To do this, you must have 100% of your money supply backed by dollars saved in your reserves.
  • Conventional fixed rate regime: A country fixes its currency with margins of +/- 1% over another currency or basket of currencies. You can use direct intervention policies (buying or selling the currency), or indirect intervention policies (lowering or raising interest rates, for example).
  • Exchange rate within horizontal bands: Allowable currency fluctuations are somewhat more flexible, for example +/- 2%. Also known as the target zone type.
  • Moving exchange rate: This rate is adjusted periodically, usually adjusting for higher inflation relative to the pegged currency. It can be done passively or actively, announced in advance and implementing the announced settings.
  • Exchange rate with moving bands: It is similar to the type with horizontal bands, but the width of the bands increases little by little. It is usually used as an intermediate step to a floating exchange rate.

Example of a fixed exchange rate

Let's imagine that the Central Bank of Argentina (BCRA) determines that the Argentine peso is equal to 5 US dollars. To set a fixed rate, the Argentine central bank will have to ensure that it can supply the market with those dollars. In other words, the central bank of Argentina must maintain large reserves of the US dollar in its reserves, so that it can ensure supply to the market and be able to exercise a strong demand for pesos if necessary, selling all the dollars you have.

The values ​​of fixed currencies rise and fall together, the fixed currency varies the same as the currency to which it is fixed. For example, if Argentina links its currency to the US dollar, and this increases in value, or on the contrary, loses part of its value, so does the Argentine peso. The latter means that the Argentine peso is in tune with the dollar. One of the consequences of pegging the currency to another country is that the central bank loses one of the fundamental tools of monetary policy, which is to devalue its currency.

When the peso is depreciating, the central bank of Argentina will buy dollars in exchange for the peso, for which it will have to print more pesos, increasing the amount of pesos that circulate in the Argentine economy, and then the value of the Argentine currency will decrease. If the peso appreciates above the fixed rate, the central bank must buy pesos in exchange for dollars. This reduces the amount of pesos that circulate in the Argentine economy, which increases the value of the currency. For this reason, it is so important to keep a large amount of money in reserve of the currency to which you want to fix, because otherwise you will not be able to maneuver to keep the exchange rate fixed.

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