Fixed Exchange Rate System Definition

The other common options of exchange rate regimes are floating exchange ratesFloating Exchange RatesThe floating exchange rate can be defined as the relative value of the currency of a country. It is determined on the basis of the demand and the supply factors prevailing in the Forex market and no attempt is made by the government for influencing such exchange rate.read more and pegged float exchange rates. When fixed regime values are set by the government or central bank of a country, the floating exchange rate is determined by the supply and demand forces in the foreign exchange marketForeign Exchange MarketThe foreign exchange market is the world’s largest financial market that decides the exchange rate of currencies.read more.

How Fixed Exchange Rate Work?

A fixed exchange rate definition explains that people can always exchange their money in one currency for the predefined amount of another currency. It’s the choice of the monetary authority of a country to choose from different exchange rate regimes. They make decisions by considering several factors like GDPGDPGDP or Gross Domestic Product refers to the monetary measurement of the overall market value of the final output produced within a country over a period.read more, political stability, reserves, and vulnerability to inflationInflationThe rise in prices of goods and services is referred to as inflation. One of the measures of inflation is the consumer price index (CPI). Rate of inflation = (CPIx+1–CPIx )/CPIx. Where CPIx is the consumer price index of the initial year, CPIx+1 is the consumer price index of the following year.read more.

Key Takeaways

  • The fixed exchange rate refers to an exchange rate regime followed by countries whose currency is anchored to another country’s currency or a valuable commodity like gold.The system helps control inflation, exchange rate certainty, and a stable environment for facilitating international trade.Qatar is an example of a country following a fixed regime. 1 United States Dollar equals 3.64 Qatari Rial.The opposite concept is the floating exchange rate system, where the value of a country’s currency is determined by the supply and demand forces relative to other currencies in the forex market.

The contrasting concept is the floating exchange regime, where the currency value fluctuates based on the forex market events. Nowadays, most countries use a floating exchange rate system since it represents the value of currency more fairly. For example, under the floating system, if one U.S. dollar is equal to 74.64 INR today, the very next day, one USD can be equal to 75.41 INR. In contrast, one USD is always around 3.67 UAE Dirham reflecting the fixed exchange regime.

Example

The financial crisisFinancial CrisisThe term “financial crisis” refers to a situation in which the market’s key financial assets experience a sharp decline in market value over a relatively short period of time, or when leading businesses are unable to pay their enormous debt, or when financing institutions face a liquidity crunch and are unable to return money to depositors, all of which cause panic in the capital markets and among investors.read more in 2019 resulted in an intense drop in Lebanese pound value. In the parallel market (black market) exchange rate reached a level of 23,000 during January 2021, even if the official exchange rate remains at 1,507.5 pounds per dollar. There is news that Lebanon’s draft budget for 2022 will project exchange rates ranging between 15,000 and 20,000 Lebanese pounds per dollar for operating expenses, planning a shift from the previously used official rate of around 1,500.

Furthermore, a retrospective of 2020 reflects that in July, the central bank of Lebanon announced that it would provide foreign currency at a fixed exchange rate of 3,900 Lebanese pounds per dollar for manufacturers and importers of essential food items. Therefore, the Lebanese central bank is advancing towards securing the necessary amounts of foreign currency to ensure the needs of stakeholdersStakeholdersA stakeholder in business refers to anyone, including a person, group, organization, government, or any other entity with a direct or indirect interest in its operations, actions, and outcomes.read more like manufacturers and importers of essential food items and inputs used in food industries. 

Advantages and Disadvantages

Every regime has its benefits and problems. Let’s look into the advantages and disadvantages of a fixed exchange rate system.

Advantages

  • It stabilizes the currency value in foreign markets, minimizes the uncertainty and risk factors by taking care of any undue fluctuations.It remains constant for a long time. Therefore, people believe it will not change shortly, eventually killing its speculations.For small countries facing a BOP (balance of paymentBalance Of PaymentThe formula for Balance of Payment is a summation of the current account, the capital account, and the financial account balances. The term balance of payments refers to the recording of all payments and obligations pertaining to imports from foreign countries vis-à-vis all payments and obligations pertaining to exports to foreign countries. It is the accounting of all the financial inflows and outflows of a nation.read more) crisis, any sudden change in the exchange rate can discourage a lot of business and market activities. It helps avoid the drastic depreciation of the currencyDepreciation Of The CurrencyCurrency depreciation is the fall in a country’s currency exchange value compared to other currencies in a floating rate system based on trade imports and exports. For example, an increase in demand for foreign products results in more imports, resulting in foreign currency investing, resulting in domestic currency depreciation.read more, which is pivotal.It encourages foreigners to make more investments in a country, taking advantage of a stable exchange rate.When a fixed rate of exchange is correctly regulated, it discourages governments from adopting unwanted macroeconomic policies.It aids in keeping the prices of goods and services regulated. It ensures that the inflation rate is minimized. A good exchange rate is characterized to be anti-inflationary.

Disadvantages

  • Under a fixed exchange regime, the currency cannot gain or devalue in response to the market forces; hence automatic adjustment of imbalances in the nation’s balance of payments will not happen automatically.The use of monetary and fiscal policyMonetary And Fiscal PolicyFiscal policy refers to the measures taken by the government in terms of tax reforms and government expenditure to influence the aggregate economic demand. In contrast, the monetary policy is the central bank measures to change interest rates for regulating the money supply in the economy.read more will not be easy.The necessary condition to maintain it is the adequate holding and foreign exchange reserves required. Therefore, it is difficult for small and developing countries.Every country has its internal problems to resolve. But unfortunately, many growth-related objectives and internal issues are often sacrificed to maintain and control the fixed exchange regime.

This has been a guide to what is fixed exchange rate system & its definition. We study fixed exchange rate regime with examples, advantages, & disadvantages. You can learn more from the following articles – 

It is a type of exchange rate regime that gained prominence after the collapse of the Bretton Wood Agreement. Under this regime, a nation’s currency value is determined by the supply and demand forces relative to other currencies in the forex market. Examples of countries following the floating exchange rate system are America, Australia, and Canada.

The most famous advantages are reducing inflation, exchange rate certainty, and creating a stable trading environment. These contribute to facilitating international trade and foreign direct investments (FDIs). 

A handful of countries like Panama, Qatar, and UAE follow a fixed regime. As a result, the currencies of such countries are tied to the U.S. dollar. For example, 1 USD equals 0.99 Panamanian Balboa, 1 USD equals 3.64 Qatari Rial, and 1 USD equals 3.67 United Arab Emirates Dirham.

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