Exchange rates in a fixed
exchange rate system
Fixed exchange rates

A fixed exchange rate system is one in which exchange rates are fixed by the
Central Bank of each country, and are not permitted to change in response
to changes in the supply and demand for currencies.

How do you think a Central Bank can make this happen?
Fixed exchange rates

A country’s Central Bank continuously buys and sells currencies held in
reserve to maintain the value of the currency at the fixed rate. It may also
make other adjustments within the domestic economy. Both practices aim
to shift the demand and supply curves in order to eliminate the
disequilibrium in the foreign exchange market
Central Bank Intervention

Assume a country experiences a decrease in the demand for it’s exports.
What will happen to the demand for that country’s currency? Under a
floating exchange system, a new equilibrium rate for the currency would be
established. Would it be higher or lower?

Because we have a fixed exchange rate policy, the Central Bank must act in
order to maintain the original exchange rate
Central Bank Intervention

In the previous example, the country is experiencing an excess supply of its
currency due to the reduced demand for its exports. In order to correct this
imbalance, the Central Bank will use foreign currency reserves to purchase
the excess supply of its currency so the original exchange rate is maintained.

If demand for the country’s exports increased, the Central Bank would
correct the problem by selling its currency and buy a different currency to
correct the problem of excess demand
Central Bank Intervention

If there is a long-term downward pressure on the country’s currency, it may
run out of reserve currency and lose the ability to maintain the fixed
exchange rate.

This won’t happen when there is excess demand for the country’s currency,
because it can always sell its own currency for a foreign currency.
So what happens when there is continued decreased demand for
the country’s currency? How can the fixed exchange rate be
maintained?
Idea #1—Limit Imports

If government enacts policies to limit imports, this will reduce the amount
of their currency supplied (because residents won’t be exchanging the
domestic currency for a foreign currency). This will shift the supply curve to
the left and keep the exchange rate at the fixed level

Government can limit imports in two different ways, can you name them?
How government can limit Imports

1—Contractionary fiscal policy or monetary policy will reduce Aggregate
Demand, lower incomes and therefore have the affect of reducing
purchases of imported goods

2—Protectionist policies such as tariffs, quotas, voluntary export restraints
and subsidies can limit the amount of imported goods entering the country
Manipulating interest rates

Another tool government has to maintain an official exchange rate is to
increase interest rates. Higher interest rates should attract foreign
investment, thus creating additional demand for the currency which will
shift the demand curve for the currency to the right
Imposing exchange controls

Exchange controls restrict the amount of foreign currency that a country’s
residents can purchase. By limiting purchases of foreign currency, the
domestic currency will not flow out of the country. Therefore the domestic
currency will strengthen
If all else fails…..

If the country is finding it too difficult to maintain the fixed exchange rate,
they can always create a new rate of exchange. If the currency has a higher
value than can be maintained through government intervention, the
currency may be devalued.

Conversely, if the currency has a lower value than can be maintained
through government intervention, the currency may be revalued.
Effects of Devaluation

Devaluation has a direct effect on imports and exports. The newly valued
currency has been depreciated, so residents are less able to import goods,
but domestic firms will find it easier to export their products. This should
lead to an increase in capital inflows to the country
Managed float

Managed exchange rates (or managed float) is a system that lies between
floating and fixed exchange rates. This has been the type of exchange rate
system used in the world since 1973. It is much closer to the floating
exchange system, but it does allow governments to make adjustments for
stabilization purposes.
Managed float

Typically, currencies under this system are flexible and changing on a daily
basis. However, in order to prevent extreme fluctuations in a given currency
which could disrupt world trade and create economic uncertainties, central
banks do intervene occasionally to keep their currency close to its long-term
equilibrium position
Managed float

The “managed” part of this exchange rate system takes place under similar
tools as we talked about before, such as:

Buying and selling currencies

Manipulating interest rates

Contractionary policies

Protectionism
Pegged exchange rates

Developing countries will occasionally peg their currencies to the US dollar
or the Euro and allow their currency to float together with it. A narrow
range of acceptable values is established for the currency within which it can
fluctuate. If the currency begins to approach the limit of the range, the
central bank will intervene to keep the currency within it’s range.
Pegged exchange rates..best of both worlds?

Pegged currencies are fixed to the value of the dollar or euro and therefore
trade within a narrow range, but they do float in relation to all other
currencies. This system has several advantages:

It helps stabilize the country’s currency in relation to the currency it is
pegged to

It creates exchange rate stability with other currencies

It facilitates trade with the country it is pegged to and other countries that
are pegged to the same currency
Overvalued and undervalued currencies

Overvalued currencies have an exchange rate that has been set at a higher
value than the equilibrium exchange rate. Undervalued currencies have an
exchange rate that has been set at a lower value than the equilibrium
exchange rate. This does not happen when exchange rates are free to float,
but does happen in the fixed or managed float system.
Overvalued currencies

Why would a country purposely overvalue its currency?
Overvalued currencies

When a country has an overvalued currency, it creates an opportunity to
buy imported goods. Developing countries may overvalue their currencies
so they can buy valuable capital goods and raw materials to kick start their
manufacturing sectors.

Unfortunately, an overvalued currency makes your country’s exports more
expensive, creates a negative trade balance, and could lead to high
unemployment rates

Eventually, developing countries have to devalue at some point to correct
these problems
Undervalued currencies

Undervalued currencies create a situation where the country’s exports are
inexpensive but imports are costly. Developing countries looking to increase
their market share globally may undervalue their currency in order to
increase employment levels .

Countries that undervalue their currencies create an unfair comparative
advantage, which can be considered cheating or engaging in a “dirty float”.