Fixed Exchange Rate

A fixed exchange rate is a regime applied by a country whereby the government or central bank ties the official exchange rate to another country's currency or the price of gold. The purpose of a fixed exchange rate system is to keep a currency's value within a narrow band.

Fixed rates provide greater certainty for exporters and importers. Fixed rates also helps the government maintain low inflation, which, in the long run, keeps interest rates down and stimulates trade and investment. Most major industrialized nations have had floating exchange rate systems since the early 1970s, while developing economies continue with fixed rate systems.

The Bretton Woods Agreement, which was applied from the end of World War II to the early 1970s, pegged the exchange rates of participating nations to the value of the U.S. dollar, which was fixed 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 removed the United States from the gold standard in 1973, he ushered in the era of floating rates.

The European Exchange Rate Mechanism 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 percent 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.

Developing economies often use a fixed-rate system to limit speculation and provide a stable system. A stable system allows 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. A fixed-rate system also prevents market adjustments when a currency becomes over or undervalued. Effective management of a fixed-rate 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.