By FMTeam If you have ever used one nation’s currency in another nation or tried to exchange it, then you may be familiar with what the exchange rate is, correct? But what exactly is a fixed exchange rate then? Well, that’s precisely when a nation simply fixes its currency exchange rate with another nation’s currency, which is usually much more stable, like the US dollar. If you are hearing about it for the very first time, then you may have a lot of questions regarding why it is such a thing and what good and bad effects it can have on a country’s economy. Well, that’s what we will be talking about in this post of Fixed exchange rate advantages and disadvantages. So, here we go.
Advantages of a Fixed Exchange Rate System
1. Stability in International Trade? Of Course!
In our opinion, one if not the biggest blessings of FER aka Fixed Exchange Rate is the stability that comes with it. Like, the way the value of the currency is stable, companies engaged in international trade can make long-term plans without any fear of sudden alterations in exchange rates, you know? Since prices are stable, importers and exporters can easily determine their selling prices with the understanding that currency fluctuations will not harm them, and that’s kinda the best bit about it all.
2. Keeps Speculators Out of the Game
Speculation is the activity of making money by betting on currency changes, and that’s not often good. Though, in a floating exchange rate system, the currency values can change frequently, hence speculation becomes common and can sometimes damage the economy. And as you can already guess, with a fixed exchange rate system where the currency value is stable, there is hardly any chance for speculators to make a profit, which is kind of a plus here.
3. Inflation? Not a Big Deal Here
Did you know that a fixed exchange rate can also work against the effects of inflation? How’s that though? Well, just so you know, inflation usually occurs when currency depreciation happens, and the prices of imported goods become too high and thus inflation. However, the stable level of the fixed price eliminates the possibility of immediate price rises as a result of rapid depreciation following either a sudden supply shock or any other factor that may make value creation more difficult.
4. Calling All Foreign Investors!
Do you know why experts say that countries that have a stable exchange rate are more likely to attract foreign investors? Well, just so you know, the reason for this likelihood of putting money in a country is the assurance that the currency would not undergo any sudden drastic changes in value, and that’s what investors like. And sure, down the line or in the long term, the presence of such foreign investments may in turn lead to economic growth, as firms and industries expand with the capital being brought in.
5. No More Worries About Currency Depreciation
Not just that though, certain developing nations also have the problem of currency depreciation that persists where their currency loses its strength compared to that of the major currencies. All in all, the fixed exchange rate is, however, a method of stabilizing this problem through constant currency value which is a great opportunity for these countries to settle down politically and avoid economic instability and crises caused by the decline in currency value.
6. Macroeconomic Discipline
What’s this one though? Well, the fixed exchange rate is a credential that the governments need to be responsible for the economic policies. Because of the fact that the currency’s value is fixed on another currency or on gold, the government is unable to print more money or apply inflation-inducing policies without risking the fixed exchange rate, and that’s always a good thing.
Disadvantages of a Fixed Exchange Rate System
1. You Lose Some Flexibility With Monetary Policy
You see, in the setting of a fixed exchange rate framework, a government kinda finds itself restrained in the exercise of its own economic policies, particularly with regard to the formulation of interest rates, but how does that work? Well, in the case of a fixed exchange rate, the utmost regard is given to the maintenance of the currency’s value, thus, the government cannot easily raise or lower interest rates according to the varying needs of the economy.
2. Watch Out for Speculative Attacks
You see, despite the fact that fixed exchange rates inhibit speculation under stable conditions, they, in contradiction, can also be points of attraction for speculative attacks under economic downturns. Like, when investors come to the conclusion that a particular country’s fixed exchange rate is not sustainable, they may quickly unleash the authenticated currency to bet a total devaluation of it. And that’s not a good situation for the nation at all.
3. External Shocks Can Hit Hard
And it is also true that countries characterized by a fixed exchange rate system could be encountered with external signs of economic chaos. In order to maintain the peg, thus, a nation is normally required to take costly measures either by putting off a voluntary change in one’s economy using foreign currency reserves or a self-initiated subordinate in rates of interest even if it is highly damaging.
4. Trade Imbalances Can Be a Bummer
Let’s start with an example, you see, if the currency of a nation is stronger than it should be, the goods of that nation become much overpriced for other countries to buy, so the result is lower exports and a trade deficit. How does that sound? Not good at all, right? All in all, if you look at the bigger picture, in total, the currency rate might not adjust naturally to stabilize the trade, and thus the country will probably face shortages of foreign exchange for a long time in the future by solving that foreign debt problem.
Conclusion
There you have it. From now on, you’ll never get confused about what a fixed exchange rate is, and whether it is a good or bad thing for a nation. Mostly though, the overall effects of the fixed exchange rate are dependent upon which currencies are tied to within this regime.