Fixed Exchange Rate Systems (AQA A Level Economics)

• A system in which the country’s Central Bank intervenes in the currency market to fix (peg) the exchange rate in relation to another currency e.g US$
  
  • When they want their currency to appreciate, they buy it on forex markets using their foreign reserves, thus increasing its demand
  • When they want their currency to depreciate, they sell it on forex markets, thus increasing its supply
    
    
• Sometimes the peg is at parity, e.g. 1 Brunei Dollar = 1 Singapore Dollar
• Often the peg is not at parity, e.g. Hong Kong has pegged its currency to the US$ at a rate of HK$ 7.75 = US$ 1
• A revaluation occurs if the Central Bank decides to change the peg and increase the strength of its currency
• A devaluation occurs if the Central Bank decides to change the peg and decrease the strength of its currency
  

Diagram: Market for Hong Kong Dollar and Market for US Dollar

The Hong Kong Monetary Authority intervenes to maintain the exchange rate of HK$ 7.75 = US$ 1

Diagram analysis

• The HK$/US$ market is shown by two market diagrams: one for the HK$ market on the left and one for the US$ market on the right
• The initial exchange rate equilibrium is found at HK$ 7.75 = US$ 1, represented by point 1
• When Hong Kong firms import goods from the USA, they demand US$ to pay for them and supply HK$
• This impacts the market for each currency: the US$ appreciates and the HK$ depreciates
• To maintain the fixed exchange rate at HK$ 7.75 = US$ 1, the Hong Kong Monetary Authority intervenes in the forex market by using US$ from its foreign reserves to buy HK$

Left diagram - HK$

• The increased supply of the HK$ shifts the supply curve to the right, which results in the value of the HK$ depreciating from (HK$7.75 = $1) → (HK$7.75 = $0.97)  and a new market equilibrium forms at point 2
• The Monetary Authority intervenes by buying HK$, which shifts the demand curve right from D₁ → D₂
• The HK$ has now been moved back to its target value of K$ 7.75 = US$ 1 - point 3

Right diagram - US$

• The increased demand for the US$ shifts the demand curve to the right, which results in the value of the US$ appreciating from ($1 = HK$7.75) → ($1 = HK$7.98)  and a new market equilibrium forms at point 2
• The Monetary Authority intervenes by buying HK$ using UD$, which increases their supply shifting the supply curve right from S₁ → S₂
• The HK$ has now been moved back to its target value of K$ 7.75 = US$ 1 - point 

• A fixed exchange rate system offers stability, reduces speculative activities, but limits monetary policy autonomy
   

The Advantages & Disadvantages of a Fixed Exchange Rate System

Advantages	Disadvantages
Provides stability and predictability for international trade and investment Businesses can plan for future costs	The central bank actively intervenes to maintain the fixed rate This limits a country's ability to independently conduct monetary policy as the focus is on exchange rate and not the interest rate
In theory, a fixed exchange rate should lower speculative trading and currency volatility	A country needs to hold a large amount of foreign reserves in order to be able to buy and sell currencies
If exchange rates are fixed, firms may be forced to be more competitive to keep inflation as low as possible  They need to keep costs costs down and increase productivity to remain competitive	Fixed exchange rates are difficult to maintain It is a complex process that needs to take into account many variables