Fixed Exchange Rate

The fixed exchange rate is also known as the pegged exchange rate. This usage is not that common though. This may be described as a kind of exchange rate regime. In this exchange rate regime the value of a particular currency is attached to the value of another currency or a group of currencies. In certain cases the value may also be pegged to gold. The value of the particular currency that has been pegged to another one depends on the performance of the same, which is also known as the reference value.

One of the major implications of the fixed exchange rate is that it does not let a government create and adhere to a particular financial policy that is free from external influences and is necessary for achieving domestic economic stability. There are certain conditions whereby the fixed exchange rates are preferred for the fact that they are highly stable.

Examples of this were seen during the financial crisis in Asia during the year 1997, when the Chinese renminbi and the Malaysian Ringgit were able to come out of critical financial crises. The Chinese renminbi fixed its rate and the Malaysian Ringgit pegged itself to the US dollar, which helped revive its economic fortunes. There is a further evidence of the stability offered by the Bretton Woods System that allowed the Western European economies to retain a certain degree of economic stability by pegging themselves to the United States dollar.

Countries, which adopt the fixed exchange rate regime, need to be careful with the entire exercise. They have to make sure that they adhere to the various imperatives of such policies. They also need to have a fair degree of confidence on the capital markets. Otherwise there are chances that the entire exercise may be a complete failure. Very common examples are Argentina and China.

When a government tries to institute a fixed exchange rate regime there are certain steps it has to take. Most of the times, the governments either sell or purchase their currencies in the open financial markets. One of the main reasons behind a government maintaining foreign currency reserves is to facilitate the entire process. In case the exchange rate goes down well below the expected rate, the government purchases the domestic currency using its reserves. This leads to an increase in the price of the currency as there is an increase in the demand for the currency in the financial markets. In case the rate of exchange exceeds the expected level then the government sells its foreign reserves.

At times the governments also make it unlawful to sell the domestic currency in another rate, because this has had several disastrous consequences like black marketing for example. However, some countries have been able to pull these measures off with certain degrees of success by way of retaining complete control over the currency conversions. A classic example of this is China in 1990s when they were able to able to hold their own against the US dollar by retaining governmental control over the currency conversion rates of the Yuan Renminbi.