Advantages & Disadvantages of a Fixed Currency Regime
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- Date Submitted: 10/26/2011 05:10 AM
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Advantages and Disadvantage of Fixed Exchange Rate Regimes
After the collapse of the Bretton Woods system many exchange rate regimes were created in an attempt to limit the volatility of floating exchange rates. A fixed exchange rate regime is referring to any regime where the monetary authority determines the exchange rate in terms of foreign currency and will trade unlimited amounts at that rate.
This includes crawling bands, crawling pegs, pegs with horizontal bands, and fixed exchange rates. As previously noted, currency boards and dollarization are also classified as fixed exchange rate regimes but of a “harder” nature.
There are three main advantages to fixed exchange rate regimes27. Firstly, as mentioned in the impossible trinity, a fixed exchange rate gives a country complete control over the stability of the exchange rate. Having a floating exchange rate can lead to volatile swings in the exchange rate which can damage trade and investment. A fixed exchange rate should eliminate this volatility, making for a more stable market.
Secondly, it is thought that by pegging the exchange rate to a low inflation currency that domestic inflation will be limited. It is believed that the peg will demonstrate a commitment to low inflation and therefore both the public and private sector will avoid unnecessary inflationary actions. The third advantage to a fixed exchange rate is also related to inflation. By pegging the exchange rate after a period of high inflation it is thought that the fixed rate will “anchor” the inflation. This is achieved through maintaining a fixed nominal exchange rate set at a level below the prevailing rate of inflation28. It must be noted that although a fixed exchange rate will anchor inflation this leads to real exchange rate overvaluation that can have adverse effects on an economy, this will be discussed further in following sections.
Having a fixed exchange rate regime also has disadvantages. Primarily, a fixed...
After the collapse of the Bretton Woods system many exchange rate regimes were created in an attempt to limit the volatility of floating exchange rates. A fixed exchange rate regime is referring to any regime where the monetary authority determines the exchange rate in terms of foreign currency and will trade unlimited amounts at that rate.
This includes crawling bands, crawling pegs, pegs with horizontal bands, and fixed exchange rates. As previously noted, currency boards and dollarization are also classified as fixed exchange rate regimes but of a “harder” nature.
There are three main advantages to fixed exchange rate regimes27. Firstly, as mentioned in the impossible trinity, a fixed exchange rate gives a country complete control over the stability of the exchange rate. Having a floating exchange rate can lead to volatile swings in the exchange rate which can damage trade and investment. A fixed exchange rate should eliminate this volatility, making for a more stable market.
Secondly, it is thought that by pegging the exchange rate to a low inflation currency that domestic inflation will be limited. It is believed that the peg will demonstrate a commitment to low inflation and therefore both the public and private sector will avoid unnecessary inflationary actions. The third advantage to a fixed exchange rate is also related to inflation. By pegging the exchange rate after a period of high inflation it is thought that the fixed rate will “anchor” the inflation. This is achieved through maintaining a fixed nominal exchange rate set at a level below the prevailing rate of inflation28. It must be noted that although a fixed exchange rate will anchor inflation this leads to real exchange rate overvaluation that can have adverse effects on an economy, this will be discussed further in following sections.
Having a fixed exchange rate regime also has disadvantages. Primarily, a fixed...