Fixed Exchange Rates: Pros, Cons, and Examples

A fixed exchange rate is when a country ties the value of its currency to some other widely-used commodity or currency. The dollar is used for most transactions in international trade. Today, most fixed exchange rates are pegged to the U.S. dollar. Countries also fix their currencies to that of their most frequent trading partners.

Brief History and Definition

In the past, currencies were fixed to an ounce of gold. In the 1944 Bretton Woods Agreement, countries agreed to peg all currencies to the U.S. dollar. The United States agreed to redeem all dollars for gold. In 1971, President Nixon took the dollar off of the gold standard to end the recession. Nixon's action ended the 100-year history of the gold standard. Still, many countries kept their currencies pegged to the dollar, because the dollar is the world's reserve currency.

A fixed exchange rate tells you that you can always exchange your money in one currency for the same amount of another currency. It allows you to determine how much of one currency you can trade for another. For example, if you go to Saudi Arabia, you always know a dollar will buy you 3.75 Saudi riyals, since the dollar's exchange rate in riyals is fixed. Saudi Arabia did that because its primary export, oil, is priced in U.S. dollars. All oil contracts and most commodities contracts around the world are written and executed in dollars.

Advantages

A fixed exchange rate provides currency stability. Investors always know what the currency is worth. That makes the country's businesses attractive to foreign direct investors. They don't have to protect themselves from wild swings in the currency's value. They are hedging their currency risk.

A country can avoid inflation if it fixes its currency to a popular one like the U.S. dollar or euro. It benefits from the strength of that country's economy. As the United States or European Union grows, its currency does as well. Without that fixed exchange rate, the smaller country's currency will slide. As a result, the imports from the large economy become more expensive. That imports inflation, as well as goods. 

For example, the U.S. dollar's value is 3.75 Saudi riyals. If the dollar strengthens 20% against the euro, the value of the riyal, which is fixed to the dollar, has also risen 20% against the euro. To purchase French pastries, the Saudis pay less than they did before the dollar strengthened. For this reason, the Saudis didn't need to limit supply as oil prices fell to $50 a barrel in 2014. The value of money is what it purchases for you. If most of your country's imports are to a single country, then a fixed exchange rate in that currency will stabilize prices.

One country that is loosening its fixed exchange rate is China. It ties the value of its currency, the yuan, to a basket of currencies that includes the dollar. In August 2015, it allowed the fixed rate to vary according to the prior day's closing rate. It keeps the yuan in a tight 2% trading range around that value. 

China has to manually adjust the exchange rate of the yuan to the dollar. This is advantageous to China, but not for the U.S. That's why the U.S. government has pressured the Chinese government to let the yuan rise in value. That action would effectively make U.S. exports cheaper in China, while Chinese exports would be more expensive in the U.S. In other words, it's an attempt by the U.S. to lower its trade deficit with China.

Disadvantages

A fixed exchange rate can be expensive to maintain. A country must have enough foreign exchange reserves to manage its currency's value. 

A fixed exchange rate can make a country's currency a target for speculators. They can short the currency, artificially driving its value down. That forces the country's central bank to convert its foreign exchange, so it can prop up its currency's value. If it doesn't have enough foreign currency on hand, it will have to raise interest rates. That will cause a recession.

That happened to the British pound in 1992. The pound was pegged to Germany's mark, but Britain had higher inflation than Germany, and the already-high interest rates in the UK left its central bank with little wiggle room to adjust for inflation differences. George Soros kept shorting the pound until the U.K. central bank gave in and allowed the pound to float. In 2015, it happened when Switzerland had to release the Swiss franc from its fix to the euro, which had plummeted in value.

Examples

There are several ways countries maintain a fixed exchange rate. The purest form is when its currency is pegged to a set value against a single currency. Alternatively, many countries fix a set value to a basket of currencies, instead of just one currency. Other countries peg it to either a single currency or to a basket of currencies, but then allow it to fluctuate within a range of the pegged currency. Here are examples of each type.

Currencies fixed at a set value to a single currency: These are the nations that promise to always give the same amount in their currency for each unit of currency to which it is fixed. The list is based on a report released in April 2019 by the International Monetary Fund.

In addition to the countries on the table, there are 14 countries that use common fixed currencies. There are seven countries in Central Africa that use the Central African CFA franc: Cameroon, Central African Republic, Chad, Equatorial Guinea, Gabon, and the Republic of the Congo. There are seven countries in West Africa that use the West African CFA franc: Benin, Burkina Faso, Guinea-Bissau, Ivory Coast, Mali, Niger, Senegal, and Togo. Each currency is tied to the euro at the same ratio—655.957 CFA to one euro.

There are also four countries that maintain a fixed exchange rate, but for a basket of currencies rather than a single currency: Fiji, Kuwait, Morocco, and Libya.

Loosely fixed currencies: These countries fix their currencies to a trading range tied to either a single or a basket of currencies.

Frequently Asked Questions (FAQs)