Fixed exchange rates – What are fixed exchange rates?
A fixed exchange rate – also known as a pegged exchange rate – is a system of currency exchange in which the value of one currency is tied to another.
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By pegging one currency to another, there’s less fluctuation when exchanging money or trading between countries. Currencies with fixed exchange rates are therefore more stable and less influenced by market conditions than currencies with floating exchange rates.
Fixed exchange rates can also be set by pegging a currency to a group of other currencies or to a different measure of value, such as the price of gold – although this is much less common.
Currencies with fixed exchange rates are usually pegged to a more stable or globally prominent currency, such as the euro or the US dollar.
For example, the Danish krone (DKK) is pegged to the euro at a central rate of 746.038 kroner per 100 euro, with a ‘fluctuation band’ of +/- 2.25 per cent.
This means that the euro to DKK exchange rate must be with 2.25% of the central rate and can’t drop below 729.252 DKK per 100 euro or exceed more than 762.824 per 100 euro.
In some cases, countries can be part of an informal currency union whereby multiple countries share a single currency. Individual nations issue their own coins and banknotes, which are pegged at par value – and are therefore exchangeable with – the main currency.
For example, Gibraltar, Jersey, and Guernsey are part of a currency union with the UK. This means that Gibraltar pounds, Jersey pounds, and Guernsey pounds are fixed to – and are exchangeable with – the British pound.
However, while the British pound can be used interchangeably with local currencies, the Gibraltar pound, the Jersey pound, and the Guernsey pound are not legal tender on the British mainland.
A fixed exchange rate system is designed to ensure that the value of a currency stays within a very narrow range. This has several advantages, particularly for smaller or developing economies.
The advantages of a fixed exchange rate include:
Providing greater certainty for importers and exporters, therefore encouraging more international trade and investment
Helping the government maintain low inflation, which can have positive long-term effects such as keeping down interest rates
However, there are also several disadvantages of fixed exchange rates, particularly for larger and more developed economies.
The disadvantages of a fixed exchange rate include:
Preventing adjustments for currencies that become under- or over-valued
Limiting the extent to which central banks can adjust interest rates for economic growth
Requiring a large pool of reserves to support the currency if it comes under pressure