Where the currency of one country is linked to the currency of another country
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A fixed exchange rate is an exchange rate where the currency of one country is linked to the currency of another country or a commonly traded commodity like gold or oil. Nowadays, countries usually link their currencies to their trading partners like the United States dollar.
For example, the United Arab Emirates pegs its currency, the UAE dirham, to 0.27 United States dollar. In other words, for 1 USD, you will always get 3.67 dirhams. It was done to provide stability in the oil trade between the two countries.
A fixed exchange rate is an exchange rate where the currency of one country is linked to the currency of another country or a commonly traded commodity so they can trade freely and smoothly with each other.
The main issue with fixed exchange rates is that it limits a central bank’s ability to adjust interest rates to affect a country’s growth rate.
A fixed exchange rate can be maintained if the two countries ensure strict capital controls.
Advantages of a Fixed Exchange Rate
Setting a fixed exchange rate with your trading partner will provide currency rate certainty to importers and exporters.
When a small country fixes its currency to a superpower like the United States and the European Union, they protect themselves from paying more when importing products from the developed countries. This appreciation happens when the U.S. economy grows, which strengthens the dollar, thereby making it expensive for the smaller countries to import. Hence, a fixed exchange rate hedges them from such a risk.
A fixed exchange rate helps to ensure the smooth flow of money from one country to another. It helps smaller and less developed countries to attract foreign investment. It also helps the smaller countries to avoid devaluation of their currency and keep inflation stable.
Disadvantages of a Fixed Exchange Rate
In a floating exchange rate, when the trade account deficit increases, the country needs to borrow more of the foreign currency. Hence, the price of the foreign currency goes up, which also pushes the price of foreign goods up in the domestic market. It reduces the demand for the foreign goods and brings down the trade deficit. However, this rebalancing is not possible in the case of a fixed exchange rate.
Fixed exchange rates will limit the central banks’ freedom to make adjustments to the interest rates to boost the economy.
Capital Market Arbitrage
A floating exchange rate helps the central bank to ensure the stability of the economy, as it is not bound by any rules to maintain the exchange rate. Also, with a floating rate, the money supply can be used to its best use.
When the money moves freely between countries, the issue with adopting a fixed interest rate is that the country linking its currency needs to conduct its monetary policy similar to the reference country. It also means that the interest rates need to be similar to maintain the fixed exchange rate. If it doesn’t happen, the country with the low interest rate will push its money supply to the country with the higher interest rate until the interest rates become equal again. Such a phenomenon is called capital market arbitrage.
For example, suppose the Reserve Bank of India (RBI) wants to link the Indian rupee to the United States dollar. The main objective of the RBI is to maintain the stability of its prices. If inflation starts to rise in India, then the RBI would want to increase the interest rates to control the price rise.
Since the Indian rupee is linked to the United States dollar, the RBI would need to keep the rates similar to the U.S. However, to control inflation, India increases its interest rates. The move makes the Indian rupee more attractive, and money flows from the U.S. to India.
To meet the demand of the Indian rupee, the RBI will increase the supply of its currency. However, the increase in money supply will lead to inflation, which goes against the main objective of the RBI.
Hence, when the movement of money between countries is smooth, it is best to either adopt a floating rate or set a rate domestically, but not both.
Fixed exchange rates are best for countries with similar macro-economic factors and have the same economic strength; for example, the U.S. and the European Union. If countries still want to set a fixed exchange rate, they can maintain such a relationship without impacting their interest rates by adopting strict capital controls. They can control the inflow of foreign investment in the country and also restrict transferring funds outside the country. Doing so will help maintain stability in the exchange rates.
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