The fixed exchange rate, also known as pegged exchange rate is that exchange rate where the value of currency is paired with another currency’s value or a group of currencies. It is usually adopted with a mind to have a stabilizing effect on the value of domestic currency against foreign currencies. It simplifies issues of international trade between two countries as expectations are more or less defined. Within limits, it is also a tool for control of inflation. It also restricts governments from manipulating domestic policy to serve the requirements for economic stability on a macro level.
So how does a government maintain a fixed exchange rate? Usually a government achieves this by simply trading its currency on the international market. This explains the need for governments to keep a stock of foreign currency. What usually takes place here is a kind of speculation game by the government. If the exchange rate drops, then the government purchases its own currency and uses it as a reserve. This creates a demand for that particular currency and it increases the price. If the exchange rates rise then the government sells its currency which results in an increase in its foreign reserves.
Another method of maintaining exchange rates by governments is by monopolizing the rate by making trading of currency at any other rate illegal. Even though this practice gives rise to a black market, several countries have had considerable success by adopting this system. China is a good example of a country which has managed to maintain a monopoly on its currency rate.
Although Fixed Exchange Rate Regimes are designed to have a stabilizing influence on governments, there are several criticisms leveled against this system. A few of them are as follows:
Capital control is the monetary policy of a country to regulate the flow of capital in and out of the country. It is a restriction on free movement of capital. Capital control is basically a device meant to dampen volatility in capital markets. This is mainly intended to control the spikes which may occur in capital markets which can be damaging to the economy on the whole. Capital control may be exercised on inflows or outflows, depending on where the priority lies. According to the IMF, most countries place controls on inflows as a response to the abnormal growth of certain sectors in the country. These controls are placed in areas where the foreign exchange reserves of the country are at risk of getting depleted.
It is not entirely true that the fixed exchange regime facilitates stability. This system can invite “speculative attacks” in the economy by unscrupulous traders and the only means of controlling this is through the system of capital control. In this context, we should consider a fixed rate regime as part of capital control.
A good example is that of China, where, since 1996, free exchange was permitted in respect to current account transactions. So while both the systems have their advantages and disadvantages, it could be concluded that a balanced combination of both systems is paramount to the healthy economic growth of a country.
It becomes apparent that governments need to exercise some control on money markets if any element of fair play is be maintained. Moreover, historically speaking, the Great Depression of 1929-30 bears witness to the extent of economic damage possible as a consequence of governments neglecting to monitor money markets efficiently. Similarly, the recent recession also demonstrates that money markets cannot be allowed to grow without any checks and balances – some control has to be applied if economies are to grow in a healthy way.