4.14 - Fixed Exchange Rates

The meaning of fixed exchange rate systems

A fixed exchange rate system involves a government setting the value of its currency against another major currency, such as the US dollar or the euro, and keeping it at that level. The central bank intervenes in the foreign exchange market to ensure the rate stays constant.

Economic model of fixed exchange rates

Suppose country A pegs its currency, currency A, against the US dollar at the target rate e*. The diagram below plots the price of A in US dollars against the quantity of A traded per period. While demand is D1 for A and supply is S1 of A, the market settles at e* on its own, so the central bank has no reason to intervene.

Now suppose rising inflation at home makes imports more attractive. Paying for those imports means selling currency A, so the supply of A shifts right from S1 of A to S2 of A: the 1st shift (increase in imports) on the diagram. At the pegged rate e* the quantity supplied is now F while the quantity demanded is only H, leaving excess supply (HF) of currency A each period, and that excess supply presses the rate down towards e'.

The rate stays at e* only if the central bank removes the excess supply by increasing demand for its own currency, shifting demand right from D1 for A to D2 for A: the 2nd shift (response by the central bank). Demand and supply then meet again at F, with the rate back at the set level e*.

Currency bands in fixed exchange rate systems

Some fixed exchange rate systems permit limited flexibility by allowing the currency to move within specified bands around a central fixed rate. For example, under the EU's ERM II, Denmark has held the krone within ±2.25% of a central rate of 7.46038 kroner per euro since 1999.

Defending against devaluation pressure

Devaluation pressure occurs when there is excess supply of the domestic currency in foreign exchange markets, pushing its value down. The central bank must increase demand to defend the fixed rate.

Ways to defend against devaluation pressure:

• Buying domestic currency - The central bank uses its foreign exchange reserves to purchase its own currency, reducing excess supply.
• Raising interest rates - Higher interest rates attract foreign investors to buy domestic bonds and deposits, increasing demand for the currency through capital inflows.
• Official borrowing - The government borrows foreign currency from international sources to buy back its own currency.
• Restricting imports and foreign exchange access - Limits on imports reduce the outflow of domestic currency, while exchange controls restrict access to foreign currency, though this can encourage illegal markets.

Countering revaluation pressure

Revaluation pressure happens when there is excess demand for the domestic currency, pushing its value up. The central bank must increase supply to keep the fixed rate.

Ways to counter revaluation pressure:

• Selling domestic currency - The central bank sells its own currency in exchange for foreign currencies, increasing supply to reduce upward pressure.
• Lowering interest rates - Reduced rates make domestic investments less attractive to foreign investors, decreasing demand for the currency.

Both approaches can expand the money supply, potentially causing inflation in the economy.

Consequences and limits of maintenance methods

While methods to maintain fixed exchange rates can stabilise currency values, they come with economic costs and practical limits.

Consequences of using interest rates

Raising interest rates to attract capital inflows can slow economic growth and increase unemployment by making borrowing more expensive for businesses and consumers.

Limitations of foreign exchange reserves and borrowing

• Finite reserves - Central banks have limited foreign currency reserves, so they cannot indefinitely buy their own currency to defend against devaluation.
• Borrowing costs - Official loans provide temporary relief but create future repayment burdens, adding long-term strain on the economy.

Issues with restrictions

Import limits and exchange controls can distort trade and lead to inefficiencies, such as the emergence of black markets for foreign currency.