Fixed Exchange Rate

When the value of a currency is pegged to the value of another currency. E.g Yuan to $
For example, the Chinese government pegged the Yuan to the dollar.

Example peg, 7 Yuan to $1

If the value of the dollar increases then the Chinese Central Bank will intervene by selling their reserves of the $ to buy the Yuan. This causes the $ to fall in value and the Yuan to rise in value. They will meet at 7 Yuan = $1

If the value of the dollar falls, then the Chinese Central Bank will intervene by selling their reserves of the Yuan to buy the $. This causes the Yuan to fall in value and the $ to rise in value. They will meet at 7 Yuan = $1

Benefits

  • Trade and Investment
    • Currency stability can promote trade because of less currency risk
  • Used as a way of controlling inflation.
    • Causes deflation if pegged to a low level
  • Can fix high to reduce the cost of imports
    • Reduces the cost of production and inflation.
  • Less need for hedging
    • Hedging is insurance against currency fluctuation. It is a type of insurance
  • Countries have to focus in which they can improve their competitiveness without depreciating their ER, these tend to be more long run in nature.
    • Have to use supply side policies etc.

Winners / Losers from China pegging ER low

Winners

  1. Consumers (in the US)
    • They get cheaper goods and services
  2. Tourists (US->China)
  3. Large imports
    • E.g. Apple, cheap manufacturing

Losers

  1. US firms who export to China
  2. US Domestic producers - Cannot compete

Drawbacks of a Fixed ER

  • More likely that there is currency speculation / speculative attack.
    • This when currency traders buy up a fixed currency hoping that the central bank will run out of reserves
    • Trader in one bank buys up currency
    • Central bank responds by selling reserves of local currency
    • Other banks join the speculative attack
    • They hope that the central bank runs out of local currency reserves
    • They can then sell it off for profit, and causes a massive drop in ER for the country
    • Small countries are more vulnerable
  • Don't have free control of monetary policy - have to keep in mind peg