Fixed exchange rates

A fixed exchange rate means that the exchange ratio between two currencies is set and can only be changed under specific conditions.

Exchange Ratios Between Currencies

Within a fixed exchange rate system, two or more countries agree on an exchange rate between their currencies (as was the case with the Bretton Woods system), or a country pegs its currency unilaterally to another currency—for example, the Bosnian Convertible Mark or the Bulgarian Lev, both of which are pegged to the euro. Typically, a weaker economy pegs its currency to that of a stronger one.

With the Bretton Woods system, one of the most complex fixed exchange rate systems in history was developed at the end of World War II. Western European countries fixed their domestic currencies to the American lead currency, the U.S. dollar. The dollar, in turn, was pegged to the price of gold. Ensuring the fixed exchange rate was the responsibility of each country’s central bank. The U.S. Federal Reserve was free to choose its own monetary policy but had to maintain sufficient gold reserves.

Under a fixed exchange rate, the central bank of the respective country ensures that its currency’s exchange rate remains stable relative to the anchor currency. Small fluctuations are usually permitted. However, the central bank must intervene in cases of significant deviations—such as when many citizens exchange domestic currency for foreign currency during a crisis, or when large amounts of capital suddenly flow into the country due to a resource discovery.

Example of a Fixed Exchange Rate Intervention

Assume a fixed exchange rate of 1:1 between the U.S. dollar and the euro has been agreed upon. This means one dollar exchanges for one euro.

1. Scenario: the dollar depreciatesDue to political instability or rising foreign commodity prices, the exchange rate shifts to 1.2:1 (one euro now buys 1.2 dollars). The dollar has become cheaper; one dollar costs only 0.83 euros. But such a depreciation is not allowed under a fixed regime.→ The European Central Bank must intervene by printing euros and selling them on the foreign exchange market. This increases the supply of euros, making the euro cheaper, pushing the exchange rate back to the agreed 1:1.

2. Scenario: the dollar appreciatesSuppose the exchange rate rises to 0.8:1 (one euro now buys only 0.8 dollars). The dollar has become more expensive.→ The European Central Bank sells U.S. dollars from its reserves, increasing the supply of dollars. According to supply and demand, a higher supply lowers the price, pushing the exchange rate back to 1:1.If the country does not have sufficient foreign exchange reserves, it is forced to devalue its currency or abandon the peg.

   
   

No System Is Purely Advantageous

A fixed exchange rate eliminates exchange rate risk, as no major short-term appreciation or depreciation is expected. If a company orders a machine that will be delivered in a year, it can be confident that it will pay the same price across currencies. The supplier likewise knows that it will receive a payment of equal purchasing power. Both parties avoid speculation about future currency movements, making long-term contracts easier to establish.

This is why Austria pegged its schilling to the German mark—to enable domestic companies to supply major German automobile manufacturers over the long term and to maintain cross-border supply chains.

Foreign exchange forwards (agreements on fixed purchase prices at a fixed date) become unnecessary for private companies, since the exchange rate risk is eliminated. Central banks, however, still must intervene and assess risks of appreciation or depreciation. Under fixed exchange rates, central banks lose autonomy in monetary policy, because they must maintain the exchange rate. For example, if they raised interest rates sharply to fight inflation, supply chains could collapse due to sudden currency misalignments—one reason why the 2008 global financial crisis quickly escalated into a euro crisis.

In addition, the domestic interest rate must match the interest rate of the country to which the currency is pegged. If domestic inflation is higher than foreign inflation, domestic prices rise faster, making local goods more expensive and reducing exports.

Figure 2

Currencies have a strong psychological component. During the euro crisis, 60% of Germans stated that introducing the common currency had not been a good idea, and 85% said the euro’s introduction had been accompanied by price increases. The euro is, de facto, an irreversible fixed exchange rate regime.(Source: Statista, 2011)

Here is the English translation:

Another frequent problem under fixed exchange rates is an imbalanced balance of payments. Goods and financial flows must balance each other out. If they do not, imbalances arise between countries.

Imagine Italy and Greece both produce olives. Both operate under a fixed exchange rate of 1,000 Italian lire to 100 Greek drachmas. The price in Italy is 100 lire per kilogram, while in Greece it is 10 drachmas per kilogram. Thus, prices align with the exchange rate.

Now assume that due to a new technology (e.g., better harvesting equipment), Greece can produce olives at 8 drachmas per kilogram. These olives now cost 80 lire in Italy instead of 100, making them considerably more competitive. Italy would export fewer olives to Greece, while Greece would export more to Italy.

This creates a trade balance deficit for Italy.

This imbalance is also reflected in the balance of payments: Italy transfers Italian lire to Greece in exchange for olives. As a result, more lire circulate on international financial markets compared to a roughly constant amount of drachmas. The drachma becomes more valuable—its price rises—because Greeks can effectively buy more olives per drachma.

However, this appreciation pressure is not allowed under fixed exchange rate regimes. Yet the forces of supply and demand naturally push toward an equilibrium exchange rate.

The Euro as an Example of an Irreversible Fixed Exchange Rate Regime

Before the euro, Europe had a more flexible system: the European Monetary System (EMS). Member countries agreed on fixed exchange rates with wide fluctuation bands between their national currencies. On December 31, 1998, these exchange rates were permanently fixed. The next day, January 1, 1999, the euro was introduced as legal tender.

Only ten years later, during the Eurozone crisis, the common European currency came under pressure due to increasingly divergent national current account balances.

Argentina also introduced a fixed exchange rate with the U.S. dollar in 1991. While the exchange rate remained constant, Argentinian inflation was significantly higher than U.S. inflation from the beginning. As prices in Argentina rose far above those in the U.S., Argentina was eventually forced to revalue the peso dramatically.

The country lost competitiveness because it produced goods at higher costs than the U.S. Practically overnight, Argentina lost eight percent of its industrial output and subsequently had to declare state bankruptcy.