Fixed Exchange Rates – What are they? + Adv and Disadvs

What are Fixed Exchange Rates?

A Fixed Exchange Rate are the price of their currency being kept at a certain level against at another currency. This is normally set by the government. 

From Google Images; Fixed Exchange Rates

However many countries would normally used to be part of a SEMI FIXED EXCHANGE RATE. This is an exchange rate which can fluctuate within a small target level. The ERM- Exchange Rate Mechanism was part of an semi exchange rate.

What are the Advantages of a fixed exchange rate? 

  • Avoid Currency Fluctuations– Countries that are in trade with other countries can be affected with fluctuating currency. For example if the UK Sterling appreciates rapidly would mean exports would be more expensive therefore be less competitive probably leading to some firms going out of business. 
  • Stability encourages investment-  If there is a lack of certainty regarding the currencies this may restrict the investment from domestic firms and also foreign firms. So a fixed exchange rate would enable stable prices so firms would know what they will be potentially earning and therefore invest for the future.
  • Keeping Inflation Low- If there is a floating exchange rate and there is a devluation this may cause inflationary pressure as imports would be expensive therefore firms would have to put up prices causing cost push inflation

Disadvantages

  • Conflict with other Macroeconomic objectives: Lets say there is a devaluation of the currency below the lower band, the GVT would have to act and the best way is to increase interest rates to attract hot money flows to cause the currency to appreciate. However this has adverse effects for example- disincentives to spend by consumers, disincentive to invest by firms. Leading to a potential decrease to Aggregate Demand.
  • Different countries are at different rates of growth and inflation
  • Less Flexibility – Doesn’t give a chance for devaluing if a commodity like oil, gas suddenly goes up in price.
  • The Wrong Rate– This is as sometimes country joins at the wrong rate and it could be too high meaning that exports would be uncompetitive. This could also cause Current Account Imbalances aswell
  • Speculation- if the speculators think that the pound is overvalued and then they will try to sell more pounds- supply shifts to the right causing the governments to decide if it needs to be devalued. As supply could shift to the right again if banks and other financial institutions sell as it has no prospect for it. Therefore it will force the government to devalue and the speculators will buy the devalued price and gain.

 

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