CFA Level 1

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Global Economic Analysis - Fixed vs. Pegged Exchange Rate Systems

A fixed exchange rate system maintains fixed exchange rates between currencies; those rates are referred to as official parity. A nation with fixed exchange rates must enforce those rates. An early form of fixed exchange rates was to specify the value of a nation's currency in terms of gold (the "gold standard").

The Gold Standard
The gold standard system worked reasonably well during the 1800s, but it was gradually disbanded during the twentieth century. In 1944, leading non-communist nations agreed on a fixed exchange rate system (the Bretton Woods System) whereby the value of the U.S. dollar was pegged at $35 per ounce and other nations then fixed the value of their currencies in relation to the U.S. dollar. Private individuals could not acquire gold at that price; only governments traded gold at that price. During the 1960s, the U.S. government pursued an expansionary monetary policy in an attempt to finance the Vietnam War and increase domestic entitlement programs ("guns and butter") without raising taxes. The inflationary monetary policy induced nations to begin a run on U.S. gold, and the U.S. was forced to stop redeeming dollars for gold and break the fixed exchange rate system that had been started in 1944.

Read more on the Gold Standard's rise and fall in the following article:
The Gold Standard Revisited

A nation operating under a fixed exchange rate system (pegged to the dollar) that experiences a balance of payments deficit will be forced to finance the deficit out of its dollar reserves. As the number of dollars declines, the nation's money supply is reduced. This causes prices to drop and interest rates to increase. The price drops make the nation's goods more competitive internationally; the higher interest rates also cause more capital to flow into the country. These forces help the nation to achieve equilibrium with its balance of payments.

The advantages of fixed exchange rate systems include the elimination of exchange rate risk, at least in the short run. They also bring discipline to government monetary and fiscal policies. Disadvantages include lack of monetary independence and increases in currency speculation regarding possible revaluations.

Pegged Exchange Rate System
A pegged exchange rate system is a hybrid of fixed and floating exchange rate regimes. Typically, a country will "peg" its currency to a major currency such as the U.S. dollar, or to a basket of currencies. The choice of the currency (or basket of currencies) is affected by the currencies in which the country's external debt is denominated and the extent to which the country's trade is concentrated with particular trading partners. The case for pegging to a single currency is made stronger if the peg is to the currency of a principal trading partner. If much of the country's debt is denominated in other currencies, the choice of which currency to peg it to becomes more complicated.

Typically, with a pegged exchange rate, an initial target exchange rate is set and the actual exchange rate will be allowed to fluctuate in a range around that initial target rate. Also, given changes in economic fundamentals, the target exchange rate may be modified.

Pegged exchange rates are typically used by smaller countries. To defend a particular rate, they may need to resort to central bank intervention, the imposition of tariffs or quotas, or the placement of restrictions on capital flow. If the pegged exchange rate is too far from the actual market rate, it will be costly to defend and it will probably not last. Currency speculators may benefit from such a situation.Advantages of pegged exchange rates include a reduction in the volatility of the exchange rate (at least in the short-run) and the imposition of some discipline on government policies. One disadvantage is that it can introduce currency speculation.

Absolute and Relative Purchasing Power Parity
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