Fixed Exchange Rate & Its Macroeconomic Impact

Fixed exchange rate is also known as pegged exchange rate. Under this exchange rate regime, a country’s currency is tied to the value of another single currency e.g. dollar or a basket of currencies e.g. euro or to gold

How it works?

Malaysian government used to peg RM3.80- $1 during the Asian financial crisis. Say, value of RM falls becoming RM4 per $1, the government will enter into foreign exchange market & buy RM using dollar. Increase in the demand for RM, will push its value up. This is main reason why governments must have reserves of foreign currency. In case if RM strengthens against dollar say RM3.50-$ 1, then Malaysian government will increase the supply of RM & buy dollar

Advantages of having fixed exchange rate:

(1) Stability in trade. Countries which do not adopt fixed exchange rate may at times see their currency appreciates too much against its trading partners. Japan is a good example. In period of global recession, the unwinding of yen carry trade has caused yen to appreciate significantly against dollar & euro. This has caused demand for Japanese goods to fall significantly. In case of depreciation, falling purchasing power will increase costs of imports for firms. As such profitability may be lower

(2) Create certainty. Fixed rates provide greater certainty for exporters as the trend of demand for their goods will be more apparent. This will help them to plan production systematically. Also there will be greater incentive to invest by buying capital goods, expand operation etc. This is because costs & profits are more certain. Critics mention that should UK have adopted euro currency, the inward investment will be larger as instability between euro & sterling will be eliminated. Also the Asian financial crisis was improved when China pegged its renminbi & Malaysia pegged its ringgit to US dollar

Disadvantages of adopting fixed exchange rate

(1) Unable to correct BOP deficit. Imbalance in trade can only be corrected when a country adopts flexible exchange rate. When a trade deficit occurs, there will be an increase in the demand for foreign currency. As such, its value will appreciate against local currency. That in turn, means now foreign goods are more expensive for local market. Consumption on imported goods will fall (M falls). Meanwhile, weakening of home currency will serve to boost exports (X increases). This will over the time, narrow the deficit in current account

(2) Certainty may also cause currency attack. It is undeniable that fixed exchange rate provide greater certainty & stability. However, it also depends on how high a country pegs its currency relative to another. If it is peg at an unsustainable rate, it will attract speculations that the rate cannot be maintained. UK & the ERM (Exchange Rate Mechanism) is a good example. The Lawson boom in late 1980s had caused UK to join ERM in order to reduce inflationary pressure at the rate of DM2.95 to the pound. At that period, high inflation had reduced economic activity & causing pound to lose its value rapidly. As it fell below the ERM limit, the government intervened in the exchange market by using foreign reserves to buy sterling. Also interest rates were raised at the same time, hoping that it will attract hot money

Somehow, high interest rates further slow down economic activities. Those with mortgages were unable to repay their loans. Default rates increase. House prices suffered a large freefall. UK economy went into deeper recession. Speculators like George Soros (the same person on Asian financial crisis) predicted that sterling will collapse too. So he (largest speculator) & others continuously sell the pound. Large increase in supply caused its value to fall. UK government no longer able to intervene to support its value. £27 billion of foreign reserves had been spent & was still unable to match trillions of pound traded in the market. The last measure adopted was to increase interest rates from 12% to 15%, but still the pound kept devaluing as investors knew it was unsustainable. UK government had no choice but to leave the ERM

(3) May cause other economic problems. As mentioned above, continuous intervention into the currency market will just inflict drainage of foreign reserves. Better option will be to increase interest rates to increase the value of the home currency as in this way it may attract hot money flows. Somehow, higher interest rates will slowdown economic activities. People & firms will be discouraged from spending. Unemployment will increase