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Fixed exchange rate
From Wikipedia, the free encyclopedia
A fixed exchange rate, sometimes (less commonly) called a pegged exchange rate, is a type of exchange rate regime wherein a currency's value is matched to the value of another single currency or to a basket of other currencies, or to another measure of value, such as gold. As the reference value rises and falls, so does the currency pegged to it. A currency that uses a fixed exchange rate is known as a fixed currency. The opposite of a fixed exchange rate is a floating exchange rate.
Many economists think that in most circumstances, floating exchange rates are preferable to fixed exchange rates because floating rates are responsive to the foreign exchange market. In addition, fixed exchange rates deprive governments of the use of an independent domestic monetary policy to achieve internal stability. However, in certain situations, fixed exchange rates may be preferable for their greater stability. For example, the Asian financial crisis was ameliorated by the fixed exchange rate of the Chinese renminbi, and the IMF and the World Bank now acknowledge that Malaysia's adoption of a peg to the US dollar in the aftermath of the same crisis was highly successful. Following the devastation of World War II, the Bretton Woods system allowed Western Europe to have fixed exchange rates until 1970 with the US dollar.[1]
Yet others argue that the fixed exchange rates (implemented well before the crisis) had become so immovable that it had masked valuable information needed for a market to function properly. That is, the currencies did not represent their true market value. This masking of information created volatility which encouraged speculators to "attack" the pegged currencies and as a response these countries attempt to defend their currency rather than allow it to devalue. These economists also believe that had these countries instituted floating exchange rates, as opposed to fixed exchange rates, they may very well have avoided the volatility that caused the Asian financial crisis. Countries like Malaysia adopted increased capital controls believing that the volatility of capital was the result of technology and globalization, rather than fallacious macroeconomic policies which resulted not in better stability and growth in the aftermath of the crisis but sustained pain and stagnation.
Countries adopting a fixed exchange rate must exercise careful and strict adherence to policy imperatives, and keep a degree of confidence of the capital markets in the management of such a regime, or otherwise the peg can fail. Such was the case of Argentina, where unchecked state spending and international economic shocks disbalanced the system and ended up forcing an extremely damaging devaluation (see Argentine Currency Board, Argentine economic crisis, and the Mexican peso crisis). On the opposite extreme, the People's Republic of China's fixed exchange rate with the US dollar until 2005 led to China's rapid accumulation of foreign reserves, placing an appreciating pressure on the Chinese yuan.
Maintaining a fixed exchange rate
The means by which a fixed exchange rate is maintained is essentially identical to the means by which an interest rate target is maintained. In essence currency is brought to market, or removed from market via open market operations executed by a central monetary authority. The only essential difference is the target of such an intervention. Most monetary authorities today use their positional power to target interest rates rather than exchange rates.
Floating exchange rate
A floating exchange rate or a flexible exchange rate is a type of exchange rate regime wherein a currency's value is allowed to fluctuate according to the foreign exchange market. A currency that uses a floating exchange rate is known as a floating currency. The opposite of a floating exchange rate is a fixed exchange rate.
Many Economists think that, in most circumstances, floating exchange rates are preferable to fixed exchange rates. They allow the dampening of shocks and foreign business cycles. However, in certain situations, fixed exchange rates may be preferable for their greater stability and certainty.
There is no currency in the world whose value is absolutely and entirely determined by the foreign exchange market; in cases of extreme appreciation or depreciation, a central bank will normally intervene to stabilize the currency. Thus, the exchange rate regimes of floating currencies may more technically be known as a managed float. A central bank might, for instance, allow a currency price to float freely between an upper and lower bound, a price "ceiling" and "floor". Management by the central bank may take the form of buying or selling large lots in order to provide price support or resistance, or, in the case of some national currencies, there may be legal penalties for trading outside these bounds.
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