A fixed exchange rate, is sometimes also referred to as a pegged exchange rate. It is a type of exchange rate regime in which a value of one currency is matched to the value of another single currency or to a group of other currencies, or it may also be matched to another measure of value, such as gold.
In order to stabilize the value of a currency a fixed exchange rate is usually used, vis-a-vis the currency it is pegged to. The trade and investments between the two countries is facilitated by this exchange rate regime, and it is particularly useful for small economies where external trade constitutes a large part of their GDP.
This exchange rate regime is also used as a means by which inflation is controlled. However, as there is arise and fall in the reference value, so does the same rise and fall is shown by the currency pegged to it. In addition to this, in order to achieve macroeconomic stability the use of domestic monetary policy by the government is prevented by a fixed exchange rate.
Maintaining a Fixed Exchange Rate
Typically, if a government is willing to maintain a fixed exchange rate then this can be done either by buying or selling its own currency on the open market. This is one of those reasons due to which governments maintain reserves of foreign currencies.
If the exchange rate moves too far below the desired rate, then by using its reserves the government buys its own currency off the market.By doing this greater demand is placed on the market and the price of the currency is pushed up . The opposite measures are taken in case if the exchange rate drifts too far above the desired rate.
Another, means of maintaining a fixed exchange rate is by simply making it illegal to trade currency at any other rate, but this means is less used. It is difficult to enforce it and it often leads to a black market in foreign currency. However, some countries have achieved great success at using this method it is due to the reason that the government has got monopolies over all money conversion.
The Chinese government has employed this method to maintain a currency peg or tightly banded float against the US dollar. Throughout the 1990s, China had been greatly successful at maintaining a currency peg by using a government monopoly over all currency conversion between the yuan and other currencies.
Criticisms
The main criticism of a fixed exchange rate is that in flexible exchange rates there are automatically adjustments of the balance of trade. When a trade deficit takes place, the demand for the foreign (rather than domestic) currency will be increased which in turn will push up the price of the foreign currency in terms of the domestic currency. Due to this the price of foreign goods becomes less attractive to the domestic market and thus it pushes down the trade deficit. This automatic re-balancing does not occur under fixed exchange rates.
Fixed Exchange Rate Regime vs. Capital Control
It is a misconception to belief that the fixed exchange rate regime brings with stability. Almost all speculative attacks that are made on currencies are targeted with fixed exchange rate regime, and in fact, Capital control is the main reason behind the stability of the economy system. The fixed exchange rate regime should be considered as a tool that is used to ensure the capital mobility control.
For instance, since December 1, 1996 China has permitted freely exchange for current account transactions. In more than 40 categories of capital account out there, there are about 20 of them that are convertible. These convertible accounts are mainly related to FDI. Because of the capital control, even renminbi does not fall under the managed floating exchange rate regime (but a clean floating), for foreigners it will be somewhat useless to get renminbi. So it is the capital control that matters for the dynamics of balance of payment and not the floating exchange rate regime.
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