Fixed Exchange Rate

A fixed exchange rate is an exchange-rate system in which the central bank commits to maintain a constant exchange rate between its currency and another currency (or basket) by buying and selling as needed. In a fixed system, the exchange rate does not move freely; it is set by policy. Most major economies abandoned fixed rates in the 1970s, but some small economies and some regional currency unions maintain them.

How fixed rates work

Under a fixed regime, the central bank announces a rate and commits to enforce it. If the rate is USD/ZAR = 18.50 (18.50 South African rands per US dollar), the central bank will:

• Buy dollars if the market price falls below 18.50 (using its foreign-exchange reserves).
• Sell dollars if the market price rises above 18.50 (adding to its FX reserves).

This intervention keeps the rate at exactly 18.50. In theory, the rate never moves. In practice, the central bank announces a narrow band (e.g., 18.48 to 18.52) and intervenes when the market price approaches the edges.

The trade-off: stability vs. autonomy

A fixed exchange rate provides stability. Exporters know they will receive a predictable amount of domestic currency for their foreign sales. Importers know their input costs in foreign currency. Investors are willing to move capital into a country with a predictable exchange rate.

But fixed rates come at a cost: monetary policy autonomy. If a country fixes its exchange rate to the US dollar, it cannot independently set interest rates — or if it does, interest-rate parity will force the peg to break.

Example: If the Fed raises interest rates to 5% and the South African central bank wants to keep rates at 2%, investors will borrow in South Africa (cheap) and lend in the US (expensive). They will sell rands for dollars, pushing the rand below 18.50. The central bank will be forced to buy rands using its FX reserves to maintain the peg. Eventually, the reserves run out and the central bank must either raise its own rates to match the Fed’s, or abandon the peg.

This is the impossible trinity or trilemma: you cannot simultaneously have a fixed exchange rate, free capital flows, and independent monetary policy. You can choose any two, but not all three.

Fixed rates and the gold standard

The gold standard was a fixed-rate system: each country’s currency was worth a fixed amount of gold. The pound sterling was worth a fixed amount of gold; the US dollar was worth a fixed (but different) amount of gold. This determined the USD/GBP exchange rate.

The advantage was automatic discipline: you could not inflate your currency beyond the gold backing. The disadvantage was lack of flexibility: during a recession, you could not expand the money supply to stimulate demand without devaluing your currency and breaking the commitment to gold.

The gold standard collapsed during the Great Depression as countries abandoned it one by one.

Bretton Woods and its collapse

After World War II, the Bretton Woods system established a system of fixed exchange rates, with the US dollar pegged to gold at $35/ounce and all other currencies pegged to the dollar. This system promised the stability of a gold standard with slightly more flexibility than pure gold.

By the late 1960s, inflation and capital outflows eroded the system. The US ran persistent trade deficits, and foreign central banks accumulated dollars they feared were overvalued. On August 15, 1971, the US President Nixon announced that the US would no longer redeem dollars for gold. The Bretton Woods system collapsed.

Current fixed regimes

Most developed economies use floating rates. But some countries still fix:

• Hong Kong: Pegs the Hong Kong dollar to the US dollar at 7.80.
• Saudi Arabia: Pegs the Saudi riyal to the US dollar.
• Denmark: Pegs the Danish krone to the euro (approximately 7.46).
• Eurozone: The euro is, in effect, a fixed system of currency boards among members.

These countries choose fixed rates because they prioritize stability and trade. They accept the loss of monetary autonomy — and are willing to align their interest rates with their peg currency.

See also