Fixed Exchange Rate

Reviewed by Komal | Updated on Aug 27, 2020

What is the fixed exchange rate?

A fixed exchange rate is a regime imposed by a government or central bank which ties the official exchange rate of the country's currency with the currency of another country or the gold price. A fixed exchange rate system has the aim of keeping the value of a currency within a narrow band.

Explanation of fixed exchange rate

Fixed rates give the exporters and importers greater certainty. Fixed rates also help the government maintain low inflation, holding interest rates down in the long run and increasing trade and investment. Most major industrialized nations have floating exchange-rate systems, where the foreign exchange market (forex) prices decide their currency price. For these nations, this practice began in the early 1970s, while developing economies continued with fixed-rate systems.

Disadvantages of fixed exchange rate

Developing economies commonly use a fixed rate structure to curb inflation and provide a stable system. A secure environment enables importers, exporters and investors to plan without having to worry about currency movements.

A fixed-rate structure, however, limits the ability of a central bank to change interest rates as required for boosting economic growth. Often, a fixed rate system prevents market fluctuations when a currency is over or undervalued. Effective management of a fixed-rate system also needs a large pool of reserves, when it is under pressure, to support the currency.

An unsustainable official exchange rate can also trigger a parallel, unofficial, or dual exchange rate to grow. A large gap between official and unofficial rates will draw hard currency away from the central bank, which can result in shortages of forex and periodic devaluations. These can be more detrimental for an economy than the daily adjustment of a floating currency regime.

Real-life example

Iran set a fixed exchange rate of 42,000 rials to the dollar in 2018, according to BBC News, after losing 8 per cent against the dollar in one day. The government has decided to eliminate the discrepancy between the rate traders used—60,000 rials — and the official rate, which was 37,000 at that time.