When talking about fixed exchange rates, these are often referred to as “pegged exchange rates”. With this type of regime, the value of a country’s currency is matched to another country’s currency value, a basket of multiple currencies, or it could be matched to some measure of value, which according to history has been gold, as well as silver. In most cases, fixed exchange rates are used to help stabilize a currency’s value when going against another country’s currency.
By stabilizing a currency, both investments and trades between the two countries involved becomes much easier, but also more predictable. This would be especially true for smaller economies whereby external trade makes up a large portion of the country’s GDP. However, fixed exchange rates are also beneficial when trying to control a problem of inflation. In this case, whenever the reference value increases or decreases in value, the second or pegged currency would also fluctuate.
When using the Mundell-Fleming Model, if a country has perfect capital mobility, then fixed exchange rates would be advantageous in preventing the country’s government from trying to achieve a macroeconomic stability by using domestic monetary policy. With fixed exchange rates, a currency’s value is fixed or set to another currency. Interestingly, the only primary player that uses this regime is the People’s Republic of China.
Simply put, whenever a country’s government needs to maintain fixed exchange rates, it would actually purchase or sell its own country’s currency using the open market. For this reason, it is common for different governments to keep reserves of foreign currencies on hand. That way, if their own exchange rate were to fall too far off the rate the government wants to maintain, the country’s own currency would be purchased by using the reserves. When this happens, demand on the market becomes much greater, increasing the currency’s price. On the other hand, if the country’s currency were to rise above the desired rate by too much, the government would take the opposite steps for correction.
The above is the most common reason that countries maintain fixed exchange rates but another reason that is not used as often is to make it illegal for the currency to be traded, regardless of the rate. The challenge in this scenario has to do with enforcing it. In fact, whenever fixed exchange rates are used for this purpose, risk of a black market development for foreign currency develops. However, some countries have done quite well using fixed exchange rates for this purpose but only because the government already controls money conversion. In fact, if you look at the Chinese government, this regime is common, which keeps currency tightly pegged against the United States dollar.
While some countries have done well using fixed exchange rates, there is one primary concern. In this case, the flexible exchange rate would adjust the balance of trade automatically so whenever a trade deficit develops, demand for foreign currency over domestic currency would be increased. When this happens, the price of the foreign currency would increase specific to foreign currency. As a result, cost of foreign goods is no longer as interesting to the domestic market, which then causes the trade deficit to go down.
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