Fixed Exchange-Rate System
From Halbeeg, the open encyclopedia · Af-Soomaali
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A fixed exchange-rate system is a monetary arrangement in which a government or central bank sets the value of a country's currency at a fixed level, pegging it to another currency (such as the US dollar or euro), a basket of currencies, or gold. This rate is not allowed to fluctuate on the market; it is maintained.
To maintain the rate, the central bank buys and sells foreign currency on the market. If demand falls and pressure on the domestic currency rises, the bank uses its foreign currency reserves to purchase and support its own currency. The system therefore depends on the adequacy of reserves and market confidence.
Variants
There are several degrees of rigidity. A hard peg includes a currency board, in which domestic currency is issued only in full backing of foreign reserves, and dollarization, where a country uses foreign currency directly. A soft peg includes a crawling peg, in which the rate is adjusted gradually over time, and bands, in which the rate moves within a defined range.
Benefits and Costs
Exchange-rate stability reduces risk for trade and foreign investment and can help control inflation when a currency is pegged to a country with stable prices. The cost is that a government loses independent monetary policy: interest rates and money supply must follow the needs of maintaining the peg, not domestic employment conditions.
The Impossible Trinity
The trilemma of international economics holds that a country cannot simultaneously achieve three things: a fixed exchange rate, free capital flows, and independent monetary policy. One must be sacrificed. Many countries have chosen to restrict capital flows or adopt a floating rate.
History and Crises
The Bretton Woods system after the Second World War was a fixed exchange-rate regime in which the dollar was pegged to gold, and it was abandoned in the early 1970s. Since then, many countries have adopted intermediate arrangements. When markets believe a peg cannot be sustained, a currency attack can occur, in which the central bank is forced to abandon the rate or accept devaluation.