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FIXED EXCHANGE RATE SYSTEM AND ITS PROS AND CONS

DEFINITION :A fixed exchange rate is an exchange rate system in which one currencys value is
matched against another currencys value. Fixed exchange rates are used to pinpoint the
value of one currency compared to another so that trade, investments and other transactions
between two countries are easier to prepare and complete. Fixed exchange rates can also
provide greater certainty for exporters and importers.
A fixed exchange rate is a country's exchange rate regime under which the
government or central bank ties the official exchange rate to another country's currency (or
the price of gold). The purpose of a fixed exchange rate system is to maintain a country's
currency value within a very narrow band. Also known as pegged exchange rate.
In order to maintain this fixed exchange rate, the central bank must maintain a high level
of currency reserves.
The existence and argument for these types of fixed rates is that the fixed exchange rate
facilitates trade and investment between the two countries with the pegged currencies. It can
be especially beneficial for the smaller country, which depends more heavily on international
trade.
A fixed exchange rate also has its weaknesses; once pegged to a larger countrys currency, the
smaller country can lose some control over its domestic monetary policy.

SEMI FIXED EXCHANGE RATE:-

This occurs when the government seeks to keep the value of a currency between a band of
exchange rate. In other words, the exchange rate can fluctuate within a narrow band .

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Example; Exchange rate mechanism (ERM) that was a semi fixed exchange rate where EU
countries sought to keep their currencies fixed within certain bands against the D-mark .The
ERM was the forerunner of the Euro.

BRETTON WOODS SYSTEM:One of the important system in fixed exchange rate system is that Bretton woods system.
After world war II , governments were determined to replace the gold standard with a
more flexible system.They set up the Bretton woods system , which was a system with fixed
exchange rates. The innovation here was that exchange rates were fixed but adjustable.When
one currency got too far out of line with its appropriate or fundamental value , the parity
could be adjusted.
The Bretton woods system functioned effectively for the quarter- century after
World War II. The system eventually broke down when the dollar became overvalued. The
United States abandoned the Bretton woods system in 1973, and the world moved in to the
modern era.

INTERVENTION: -

When a government fixes its exchange rate, it must intervene in foreign exchange
markets to maintain the rate. Government exchange-rate intervention occurs when the
government buys or sells foreign exchange to affect exchange rates.
Example:
The Japanese government on a given day might buy$1 billion worth of Japanese yen
with U.S.dollars. This would cause a rise in value, or an appreciation, of the yen.

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Fixed exchange rates in accounting:-

Similarly, companies that work internationally and deal in different currencies regularly can
set fixed exchange rates for their base currency matched against the foreign currency they
work with.Setting a fixed exchange rate in your accounting system.
For example:
one entire month can make things easier for companies since the exchange rate will be
fixed - as opposed to changing every day. At the end of e.g. one month, the company can
adjust for the currency fluctuation in their accounts.
Typically, companies can choose the fixed exchange rate as the average exchange rate from
the previous month.

Types of fixed exchange rate systems

The gold standard:-

Under the gold standard, a countrys government declares that it will exchange its currency
for a certain weight in gold. In a pure gold standard, a countrys government declares that it
will freely exchange currency for actual gold at the designated exchange rate. This "rule of
exchange allows anyone to go the central bank and exchange coins or currency for pure gold
or vice versa. The gold standard works on the assumption that there are no restrictions on
capital movements or export of gold by private citizens across countries.
Because the central bank must always be prepared to give out gold in exchange for coin and
currency upon demand, it must maintain gold reserves. Thus, this system ensures that the
exchange rate between currencies remains fixed. For example, under this standard, a 1 gold
coin in the United Kingdom contained 113.0016 grains of pure gold, while a $1 gold coin in
the United States contained 23.22 grains

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Price specie flow mechanism:The automatic adjustment mechanism under the gold standard is the price specie flow
mechanism, which operates so as to correct any balance of payments disequilibrium and
adjust to shocks or changes. This mechanism was originally introduced by Richard
Cantillon and later discussed by David Hume in 1752 to refute the mercantilist doctrines and
emphasize that nations could not continuously accumulate gold by exporting more than their
imports.

The assumptions of this mechanism are:1. Prices are exible


2. All transactions take place in gold
3. There is a xed supply of gold in the world
4. Gold coins are minted at a xed parity in each country
5. There are no banks and no capital ows

Reserve currency standard:-

In a reserve currency system, the currency of another country performs the functions that
gold has in a gold standard. A country fixes its own currency value to a unit of another
countrys currency, generally a currency that is prominently used in international transactions
or is the currency of a major trading partner. For example, suppose India decided to fix its
currency to the dollar at the exchange rate E/$ = 45.0. To maintain this fixed exchange rate,
the Reserve Bank of India would need to hold dollars on reserve and stand ready to exchange
rupees for dollars (or dollars for rupees) on demand at the specified exchange rate. In the gold
standard the central bank held gold to exchange for its own currency, with a reserve currency
standard it must hold a stock of the reserve currency

Gold exchange standard:-

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The fixed exchange rate system set up after World War II was a gold-exchange standard, as
was the system that prevailed between 1920 and the early 1930s.[15] A gold exchange standard
is a mixture of a reserve currency standard and a gold standard. Its characteristics are as
follows:

All non-reserve countries agree to fix their exchange rates to the chosen reserve at
some announced rate and hold a stock of reserve currency assets.

The reserve currency country fixes its currency value to a fixed weight in gold and
agrees to exchange on demand its own currency for gold with other central banks within
the system, upon demand.

Advantages of Fixed Exchange Rates:-

1. Avoid Currency Fluctuations. If the value of currencies fluctuate significantly this can
cause problems for firms engaged in trade.

For example if a firm is exporting to the US, a rapid appreciation in sterling would
make its exports uncompetitive and therefore may go out of business.

If a firm relied on imported raw materials a devaluation would increase the costs of
imports and would reduce profitability
2. Stability encourages investment. The uncertainty of exchange rate fluctuations can
reduce the incentive for firms to invest in export capacity. Some Japanese firms have said that
the UKs reluctance to join the Euro and provide a stable exchange rates maker the UK a less
desirable place to invest.

3. Keep inflation Low. Governments who allow their exchange rate to devalue may cause
inflationary pressures to occur. This is because AD increases, import prices increase and firms
have less incentive to cut costs.
4. A rapid appreciation in the exchange rate will badly effect manufacturing firms who
export, this may also cause a worsening of the current account.
5. Joining a fixed exchange rate may cause inflationary expectations to be lower
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Disadvantage of Fixed Exchange Rates:-

1. Conflict with other objectives. To maintain a fixed level of the exchange rate may
conflict with other macroeconomic objectives.
If a currency is falling below its band the government will have to intervene. It can do this
by buying sterling but this is only a short term measure.
The most effective way to increase the value of a currency is to raise interest rates. This will
increase hot money flows and also reduce inflationary pressures.
However higher interest rates will cause lower AD and economic growth, if the economy is
growing slowly this may cause a recession and rising unemployment
2. Less Flexibility. It is difficult to respond to temporary shocks. For example an oil importer
may face a balance of payments deficit if oil price increases, but in a fixed exchange rate
there is little chance to devalue.
3. Join at the Wrong Rate. It is difficult to know the right rate to join at. If the rate is too
high, it will make exports uncompetitive. If it is too low, it could cause inflation.
4. Current Account Imbalances. Fixed exchange rates can lead to current account
imbalances. For example, an overvalued exchange rate could cause a current account deficit.

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BY
J.RAM VIGNESH
BA0140047

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