When a nation maintains the value of its currency against another nation’s currency at a specific level, it can be said that the exchange rate is fixed. However, when countries join a semi-fixed exchange rate, the currency can fluctuate within a narrow target level.
Most fixed exchange rates in use today are tied to the US dollar. Nations also fix their currencies to those of their main trading partners.
Having a fixed exchange rate has several benefits, of which the top 5 are given below.
Limits Fluctuations in Currency
A big fluctuation in the value of a currency might be problematic for businesses involved in a trade. For example:
- If a company relies mainly on exports, a sharp increase in the currency value could render such exports uncompetitive, leading to the company’s demise.
- Similarly, a currency devaluation would increase import costs and lower profitability if a company relies on imports of raw goods.
A fixed exchange rate is ideal if you want to prevent currency fluctuations.
With a fixed exchange rate, your currency doesn’t fluctuate, no matter the market’s state. This implies that regardless of how the market evolves, you will be able to preserve your purchasing power. However, remembering that a fixed exchange rate also ends the possibility of arbitrage is crucial.
When one party exploits different pricing on two different markets, that is arbitrage. This issue is addressed by maintaining a fixed exchange rate, an essential safety measure.
Maintains Low Inflation
If a nation fixes its currency’s value to a widely used one, such as the US dollar or the euro, it can avoid inflation and gain from the stability of that nation’s economy. This helps maintain the costs of products and services acceptable for the general public while preventing the country’s inflation from rising.
As the US or European Union develops, their currency does as well. Without the set exchange rate, the currency of the smaller nation will fall. The imports from the developed economy consequently cost more.
For instance, 3.76 Saudi riyals equal one US dollar. Therefore, the riyal’s value, which is fixed to the US dollar, would climb 20% versus the euro if the dollar’s value is increased by 20%.
Being more stable than a floating rate system, a fixed exchange rate system promotes investment in a country due to the following reasons:
- Businesses and investors benefit from stability since they know how much their currency will be valued in other currencies.
- This keeps their assets and revenue from fluctuating, which keeps foreign direct investors interested in the nation’s businesses.
- Undoubtedly, the multiplier effect of such foreign investment boosts economic growth.
- Additionally, because it is simpler for consumers to exchange their money for the currency of the nation they want to invest in, a fixed exchange rate system also promotes trade between nations.
- Growth and investment are boosted in both nations as a result.
Discourages Uncertainty and Speculation
When a nation links its currency to that of its trading partner, it helps to ensure payment amount certainty and removes exchange rate risk and uncertainty from transactions and contracts.
With a fixed exchange rate, people anticipate that the exchange rate won’t change soon because it has been stable for some time. Thus, any speculation in the foreign exchange rate market is eliminated.
Additionally, because long-term exchange rate stability minimizes the risk of speculating, it deters capital flight. The risk of capital flight is quite high in a world with freely moving exchange rates since these exchange rates encourage speculation. Traders feel assured that overseas payments can be made safely and without risk of loss if exchange rates are fixed.
Prevents Currency Depreciation
Fixed exchange rates prevent currencies’ depreciation, especially in developing countries. For example, if a nation is experiencing a Balance of Payments (BOP) crisis, frequent exchange rate fluctuations could worsen these BOP issues. In other words, currencies depreciate as a result of unstable exchange rates. The fixed exchange rate’s stability can help in stopping this.
Additionally, a system of exchange rates enables the government to avoid implementing risky macroeconomic measures like currency devaluation. As opposed to this, it enables the government to use deflationary measures to control the BOP deficit without making any adjustments to domestic policies.
What are the advantages and disadvantages of a fixed exchange rate?
The main advantages of a fixed exchange rate include minimal currency fluctuation, low inflation, more investments, the prevention of currency depreciation, and uncertainty in the exchange rate market. As for the disadvantages, it can be costly to maintain the fixed exchange rate, and it requires big foreign exchange reserves.
Why are fixed exchange rates better than floating ones?
Fixed rates are used to compel a more careful monetary policy, whereas floating rates are advantageous for nations with a conservative monetary policy already. Therefore, for nations with smaller and less established economies, fixed exchange rates are better than fixed rates.
How does a fixed exchange rate reduce inflation?
A fixed exchange rate works as a barrier to the rise of the domestic money supply, which lowers inflation.
Why is a fixed exchange rate bad?
Fixed exchange rates are bad because they could lead to issues if you join them at the wrong value. Alternatively, exports will lose competitiveness if the exchange rate is excessively high, reducing demand and slowing growth.
Which countries use fixed exchange rates?
Many countries still have fixed exchange rates. These include Bahrain, Saudi Arabia, Cuba, UAE, etc.
How do fixed exchange rates affect businesses?
Fixed exchange rates affect businesses in different ways. For both enterprises and investors, they lower risks. Eliminating foreign exchange risk is another advantage of fixed exchange rates for businesses.
How does a fixed exchange rate affect imports, exports, and global trade?
Fixed exchange rates assist in reducing the cost of imports. Additionally, it contributes to increasing the export value. However, fixed exchange rates would impede commerce and prohibit central banks from regulating their economies today when global trade is at an all-time high.
Why are exchange rates important for businesses?
Exchange rates are crucial for businesses because they have the potential to impact two key aspects of their operations: the cost of supplies imported from other nations and the allure of their goods to clients abroad.