The meaning of fixed exchange rate systems

A fixed exchange rate system involves a government setting the value of its currency against another major currency, such as the US dollar or the euro, and keeping it at that level. The central bank intervenes in the foreign exchange market to ensure the rate stays constant.

Economic model of fixed exchange rates

If factors like rising inflation cause more imports, this increases the supply of the domestic currency in foreign exchange markets, creating excess supply and downward pressure on its value. To keep the fixed rate, the central bank must increase demand for the domestic currency, effectively shifting the demand curve to the right and restoring balance at the set rate.

Currency bands in fixed exchange rate systems

Some fixed exchange rate systems permit limited flexibility by allowing the currency to move within specified bands around a central fixed rate. For example, a currency might be allowed to vary by up to ±1.5% from the central rate.

Methods to maintain fixed exchange rates against devaluation pressure

Devaluation pressure occurs when there is excess supply of the domestic currency in foreign exchange markets, pushing its value down. The central bank must increase demand to defend the fixed rate.

Ways to defend against devaluation pressure:

• Buying domestic currency - The central bank uses its foreign exchange reserves to purchase its own currency, reducing excess supply.
• Raising interest rates - Higher interest rates attract foreign investors to buy domestic bonds and deposits, increasing demand for the currency through capital inflows.
• Official borrowing - The government borrows foreign currency from international sources to buy back its own currency.
• Restricting imports and foreign exchange access - Limits on imports reduce the outflow of domestic currency, while exchange controls restrict access to foreign currency, though this can encourage illegal markets.

Methods to counter revaluation pressure in fixed systems

Revaluation pressure happens when there is excess demand for the domestic currency, pushing its value up. The central bank must increase supply to keep the fixed rate.

Ways to counter revaluation pressure:

• Selling domestic currency - The central bank sells its own currency in exchange for foreign currencies, increasing supply to reduce upward pressure.
• Lowering interest rates - Reduced rates make domestic investments less attractive to foreign investors, decreasing demand for the currency.

Both approaches can expand the money supply, potentially causing inflation in the economy.

Consequences and limitations of maintenance methods

While methods to maintain fixed exchange rates can stabilise currency values, they come with economic costs and practical limits.

Consequences of using interest rates

Raising interest rates to attract capital inflows can slow economic growth and increase unemployment by making borrowing more expensive for businesses and consumers.

Limitations of foreign exchange reserves and borrowing

• Finite reserves - Central banks have limited foreign currency reserves, so they cannot indefinitely buy their own currency to defend against devaluation.
• Borrowing costs - Official loans provide temporary relief but create future repayment burdens, adding long-term strain on the economy.

Issues with restrictions

Import limits and exchange controls can distort trade and lead to inefficiencies, such as the emergence of black markets for foreign currency.