Foreign Exchange

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See also Bureau de change

A fixed exchange rate, sometimes (less commonly) called a pegged exchange rate, is a type of exchange rate regime wherein a currency's value is matched to the value of another single currency or to a basket of other currencies, or to another measure of value, such as gold. As the reference value rises and falls, so does the currency pegged to it. A currency that uses a fixed exchange rate is known as a fixed currency. The opposite of a fixed exchange rate is a floating exchange rate.

Many economists think that in most circumstances, floating exchange rates are preferable to fixed exchange rates because floating rates are responsive to the foreign exchange market. In addition, fixed exchange rates deprive governments of the use of an independent domestic monetary policy to achieve internal stability. However, in certain situations, fixed exchange rates may be preferable for their greater stability. For example, the Asian financial crisis was improved by the fixed exchange rate of the Chinese renminbi, and the IMF and the World Bank now acknowledge that Malaysia's adoption of a peg to the US dollar in the aftermath of the same crisis was highly successful. Following the devastation of World War II, the Bretton Woods system allowed Western Europe to have fixed exchange rates until 1970 with the US dollar. [1]

Yet others argue that the fixed exchange rates (implemented well before the crisis) had become so immovable that it had masked valuable information needed for a market to function properly. That is, the currencies did not represent their true market value. This masking of information created volatility which encouraged speculators to "attack" the pegged currencies and as a response these countries attempt to defend their currency rather than allow it to devalue. These economists also believe that had these countries instituted floating exchange rates, as opposed to fixed exchange rates, they may very well have avoided the volatility that caused the Asian financial crisis. Countries like Malaysia adopted increased capital controls believing that the volatility of capital was the result of technology and globalization, rather than fallacious macroeconomic policies which resulted not in better stability and growth in the aftermath of the crisis but sustained pain and stagnation.

Countries adopting a fixed exchange rate must exercise careful and strict adherence to policy imperatives, and keep a degree of confidence of the capital markets in the management of such a regime, or otherwise the peg can fail. Such was the case of Argentina, where unchecked state spending and international economic shocks disbalanced the system and ended up forcing an extremely damaging devaluation (see Argentine Currency Board, Argentine economic crisis, and the Mexican peso crisis). On the opposite extreme, the People's Republic of China's fixed exchange rate with the US dollar until 2005 led to China's rapid accumulation of foreign reserves, placing an appreciating pressure on the Chinese yuan.

Maintaining a fixed exchange rate

Typically, a government wanting to maintain a fixed exchange rate does so by either buying or selling its own currency on the open market. This is one reason governments maintain reserves of foreign currencies. If the exchange rate drifts too far below the desired rate, the government buys its own currency off the market using its reserves. This places greater demand on the market and pushes up the price of the currency. If the exchange rate drifts too far above the desired rate, the opposite measures are taken.

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, communist countries are highly successful at using this method due to government monopolies over all money conversion. This is the method employed by the Chinese government to maintain a currency peg or tightly banded float against the US dollar. Throughout the 1990s China was highly successful at maintaining a currency peg using a government monopoly over all currency conversion between the Yuan and currencies.

Criticisms

The main criticism of fixed exchange rate is that flexible exchange rates serve to automatically adjust the balance of trade. When a trade deficit occurs, 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 re-balancing does not occur.

Literature

• Tiwari, Rajnish (2003): Post-Crisis Exchange Rate Regimes in Southeast Asia, Seminar Paper, University of Hamburg. (PDF)

See also

• Black Wednesday
• Linked exchange rate