A fixed exchange rate is a system in which one currency is pegged to another currency.
Most of these currencies are pegged to the U.S. dollar or the euro.
The monetary authorities’ aim, in these cases, is to keep their currency’s value stable and avoid wild exchange rate fluctuations.
There are a number of advantages to a fixed exchange rate:
- Stable value
When one currency is pegged to another, the dangers of fluctuation are greatly reduced. This is particularly important for countries with weaker economies for whom sudden exchange rate fluctuations could have devastating consequences. Pegging their currency to a stronger currency protects against such volatility.
- Promotes foreign investment
Greater currency stability attracts investors as it guarantees that the value of their assets will not be suddenly wiped out due to exchange rate fluctuation. They are therefore more likely to invest.
- Helps governments to contain inflation
A fixed exchange rate provides greater stability for import/export prices and protects against the risk of currency devaluation.
- Promotes exports
Fixing the exchange rate helps governments keep the value of their currency at a level appropriate to support the export sector. This ensures that the price of products and services remains competitive in overseas markets.
Fixed exchange rates are positive for importers and exporters because they minimize currency risk.
However, the caveat is that these fixed rates are often accompanied by currency controls that hinder international transactions.