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Analysing the pros and cons of the Fixed Exchange Rate

Fixed Exchange rate definition

A Fixed exchange rate is controlled by the country’s central bank and is fixed to another currency, a basket of currencies or a scarce commodity like the price of gold.

How a fixed exchange rate works

The fixed exchange rate regime is often implemented by developing countries to foster growth by providing stability for importers and exporters.

Exporters can manage their businesses with more certainty since they can predict their revenues and profits given the fixed currency level. Importers can also plan easier since their investment costs and raw materials costs are not subject to any currency volatility.

One of the main disadvantages of a fixed exchange rate regime is that the currency is not allowed to adjust freely for the economy’s current account balance and balance of payments to self-adjust and reach an equilibrium.

Under a fixed exchange rate regime, policymakers waste resources on keeping the country’s exchange rate fixed instead on focusing on the factors that matter in an country’s economy which is to maximize economic growth, minimize unemployment and keep inflation steady.

Maintaining a fixed exchange rate regime is very restrictive for an economy’s monetary policy and has often led to negative economic and political consequences for the country.

Impossible Trinity

A Country must choose between 1. Free capital mobility (modern financial system), 2. Exchange rate management and 3. Independent monetary policy. Only two of three aims are possible. The possible scenario for a country’s monetary system are:

  1. A country with a fixed exchange rate and interest-rate autonomy cannot allow free capital to flow across
  2. A country with a fixed exchange rate and open capital flows, cannot have an independent monetary policy
  3. A country with free capital flows and monetary autonomy must allow the currency to float

For example, if a country has a fixed exchange rate with the US dollar and wants free capital movement it cannot have an independent monetary policy. If the country faces overheating in it’s economy and want’s to reduce inflation, the central bank ideally must set interest rates above the Fed rates. This will attract foreign capital which will put pressure to the currency and eventually break the currency peg.

Emerging countries want to keep a fixed exchange rate. Hence, they need to sacrifice either capital mobility by using capital controls or foreign reserve management, or their monetary policy independence.

A list of the currencies with fixed exchange rates along with notes for each one is presented below:

  • Chinese Yuan (CNH): The Chinese Yuan is allowed to fluctuate in a crawling band. The Central bank intervenes daily at 9:15am Beijing time setting the Daily CPR fixing.
  • Danish Krone (DKK): The currency is pegged to the Euro
  • Hong Kong Dollar (HKD): The Hong Kong dollar is pegged to the US dollar
  • Singapore Dollar (SGD): The Singapore Dollar is allowed to fluctuate by the central bank within a crawling band versus a currency weight index defined by the central bank. The country’s central bank has not disclosed the weights of the index nor the band.
  • Kuwaiti Dinar (KWD): The currency is pegged to a basket of world currencies. The country’s central bank has not disclosed the trade weighted index. The Kuwaiti Dinar is the strongest world currency.

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