International Finance Theory and Policy
by Steven M. Suranovic
Fixed Exchange Rate Systems
There are two basic systems that can be used to determine the exchange rate between one country’s currency and another’s; a floating exchange rate system and a fixed exchange rate system.
Under a floating exchange rate system, the value of a country’s currency is determined by the supply and demand for that currency in exchange for another in a private market operated by major international banks.
In contrast, in a fixed exchange rate system a country’s government announces, or decrees, what its currency will be worth in terms of “something else” and also sets up the “rules of exchange.” The “something else” to which a currency value is set and the “rules of exchange” determines the type of fixed exchange rate system, of which there are many. For example, if the government sets its currency value in terms of a fixed weight of gold then we have a gold standard. If the currency value is set to a fixed amount of another country’s currency, then it is a reserve currency standard.
As we review several ways in which a fixed exchange rate system can work, we will highlight some of the advantages and disadvantages of the system. In anticipation, it is worth noting that one key advantage of fixed exchange rates is the elimination of exchange rate risk, which can greatly enhance international trade and investment. A second key advantage is the discipline a fixed exchange rate system imposes on a country’s monetary authority, likely to result in a much lower inflation rate.
International Finance Theory and Policy - Chapter 80-1: Last Updated on 4/7/05