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What is a 'Fixed Exchange Rate'

A fixed exchange rate is a country's exchange rate regime under which the government or central bank ties the official exchange rate to another country's currency or to the price of gold. The purpose of a fixed exchange rate system is to maintain a country's currency value within a very narrow band.

BREAKING DOWN 'Fixed Exchange Rate'

Fixed rates provide greater certainty for exporters and importers, which also helps the government maintain low inflation, which in the long run will tend to keep interest rates down and stimulate increased trade and investment.

Most major industrialized nations have had floating exchange rate systems since the early 1970s, while developing economies continue to have fixed rate systems.

Background

The Bretton Woods Agreement, which ran from the end of World War II to the early 1970s, pegged the exchange rates of the participating nations to the value of the U.S. dollar, which in turn was pegged to the price of gold. When the United States' post-war balance of payments surplus turned to a deficit in the 1950s and 1960s, the periodic exchange rate adjustments permitted under the Agreement ultimately proved insufficient. When President Richard Nixon took the United States off the gold standard in 1973, he ushered in the era of floating rates.

The European Exchange Rate Mechanism (ERM) was established in 1979 as a precursor to monetary union and the introduction of the euro. Member nations (including Germany, France, the Netherlands, Belgium, Spain and Italy) agreed to maintain their currency rates within plus or minus 2.25% of a central point. The United Kingdom joined in October 1990 at an excessively strong conversion rate and was forced to withdraw two years later. The original members of the euro converted from their home currencies at their then-current ERM central rate as of Jan. 1, 1999. The euro itself trades freely against other major currencies, while the currencies of countries hoping to join trade in a managed float known as ERM II.

Disadvantages of Fixed Exchange Rates

Developing economies often utilize a fixed rate system to limit speculation and provide a stable system to allow importers, exporters and investors to plan without worrying about currency moves. However, a fixed rate system limits a central bank's ability to adjust interest rates as needed for economic growth. It also prevents market adjustments when a currency becomes over- or undervalued. Effective management of such a system also requires a large pool of reserves to support the currency when it is under pressure.

An unrealistic official exchange rate can also lead to the development of a parallel, unofficial exchange rate. A large gap between the official and unofficial rates can divert hard currency away from the central bank, which can lead to forex shortages and periodic large devaluations. These can be more disruptive to an economy than the periodic adjustment of a floating exchange rate regime.

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