Fixed exchange rate system - AbsoluteAstronomy.com

A fixed exchange-rate system (also known as pegged exchange rate system) is a currency system in which governments try to keep the value of their currencies constant against one another.
In a fixed exchange-rate system, a country’s government decides the worth of its currency in terms of either a fixed weight of gold, a fixed amount of another currency

Reserve currency

A reserve currency, or anchor currency, is a currency that is held in significant quantities by many governments and institutions as part of their foreign exchange reserves...

or a basket of other currencies. The central bank

Central bank

A central bank, reserve bank, or monetary authority is a public institution that usually issues the currency, regulates the money supply, and controls the interest rates in a country. Central banks often also oversee the commercial banking system of their respective countries...

of a country remains committed at all times to buy and sell its currency at a fixed price. The central bank provides foreign currency needed to finance payments imbalances

Balance of payments

Balance of payments accounts are an accounting record of all monetary transactions between a country and the rest of the world.These transactions include payments for the country's exports and imports of goods, services, financial capital, and financial transfers...

History

The gold standard

Gold standard

The gold standard is a monetary system in which the standard economic unit of account is a fixed mass of gold. There are distinct kinds of gold standard...

or gold exchange standard of fixed exchange rate

Exchange rate

In finance, an exchange rate between two currencies is the rate at which one currency will be exchanged for another. It is also regarded as the value of one country’s currency in terms of another currency...

s prevailed from about 1870 to 1914, before which many countries followed bimetallism

Bimetallism

In economics, bimetallism is a monetary standard in which the value of the monetary unit is defined as equivalent both to a certain quantity of gold and to a certain quantity of silver; such a system establishes a fixed rate of exchange between the two metals...

. The period between the two world wars was transitory, with the Bretton Woods system

Bretton Woods system

The Bretton Woods system of monetary management established the rules for commercial and financial relations among the world's major industrial states in the mid 20th century...

emerging as the new fixed exchange rate regime in the aftermath of World War II. It was formed with an intent to rebuild war-ravaged nations after World War II through a series of currency stabilization programs and infrastructure

Infrastructure

Infrastructure is basic physical and organizational structures needed for the operation of a society or enterprise, or the services and facilities necessary for an economy to function...

loans. The early 1970s witnessed the breakdown of the system and its replacement by a mixture of fluctuating and fixed exchange rates.

Chronology

Timeline of the fixed exchange rate system:

1880–1914	Classical gold standard period
April 1925	United Kingdom returns to gold standard
October 1929	United States stock market crashes Great Depression in the United States The Great Depression began with the Wall Street Crash of October, 1929 and rapidly spread worldwide. The market crash marked the beginning of a decade of high unemployment, poverty, low profits, deflation, plunging farm incomes, and lost opportunities for economic growth and personal advancement...
September 1931	United Kingdom abandons gold standard
July 1944	Bretton Woods conference
March 1947	International Monetary Fund International Monetary Fund The International Monetary Fund is an organization of 187 countries, working to foster global monetary cooperation, secure financial stability, facilitate international trade, promote high employment and sustainable economic growth, and reduce poverty around the world... comes into being
August 1971	United States suspends convertibility of dollar into gold – Bretton Woods system collapses
December 1971	Smithsonian Agreement Smithsonian Agreement The Smithsonian Agreement was a December 1971 agreement that ended the fixed exchange rates established at the Bretton Woods Conference of 1944.-History:...
March 1972	European snake Snake in the tunnel The snake in the tunnel was the first attempt at European monetary cooperation in the 1970s, aiming at limiting fluctuations between different European currencies... with 2.25% band of fluctuation allowed
March 1973	Managed float regime Managed float regime Managed float regime is the current international financial environment in which exchange rates fluctuate from day to day, but central banks attempt to influence their countries' exchange rates by buying and selling currencies... comes into being
April 1978	Jamaica Accords take effect
September 1985	Plaza accord Plaza Accord The Plaza Accord or Plaza Agreement was an agreement between the governments of France, West Germany, Japan, the United States, and the United Kingdom, to depreciate the U.S. dollar in relation to the Japanese yen and German Deutsche Mark by intervening in currency markets...
September 1992	United Kingdom and Italy Italy Italy , officially the Italian Republic languages]] under the European Charter for Regional or Minority Languages. In each of these, Italy's official name is as follows:;;;;;;;;), is a unitary parliamentary republic in South-Central Europe. To the north it borders France, Switzerland, Austria and... abandon Exchange Rate Mechanism European Exchange Rate Mechanism The European Exchange Rate Mechanism, ERM, was a system introduced by the European Community in March 1979, as part of the European Monetary System , to reduce exchange rate variability and achieve monetary stability in Europe, in preparation for Economic and Monetary Union and the introduction of... (ERM)
August 1993	European Monetary System European Monetary System There are three stages of monetary cooperation in the European Union.-Background:European currency exchange rate stability has been one of the most important objectives of European policy makers at least since the Second World War.... allows ±15% fluctuation in exchange rates

Gold standard

The earliest establishment of a gold standard was in the United Kingdom in 1821 followed by Australia in 1852 and Canada in 1853. Under this system, the external value of all currencies was denominated in terms of gold with central banks ready to buy and sell unlimited quantities of gold at the fixed price. Each central bank maintained gold reserves as their official reserve asset. For example, during the “classical” gold standard period (1879–1914), the U.S. dollar was defined as 0.048 troy oz. of pure gold

Bretton Woods system

Following the Second World War, the Bretton Woods system

Bretton Woods system

The Bretton Woods system of monetary management established the rules for commercial and financial relations among the world's major industrial states in the mid 20th century...

(1944–1973) replaced gold with the US$ as the official reserve asset. The regime intended to combine binding legal obligations with multilateral decision-making through the International Monetary Fund

International Monetary Fund

The International Monetary Fund is an organization of 187 countries, working to foster global monetary cooperation, secure financial stability, facilitate international trade, promote high employment and sustainable economic growth, and reduce poverty around the world...

(IMF). The rules of this system were set forth in the articles of agreement of the IMF and the International Bank for Reconstruction and Development

International Bank for Reconstruction and Development

The International Bank for Reconstruction and Development is one of five institutions that compose the World Bank Group. The IBRD is an international organization whose original mission was to finance the reconstruction of nations devastated by World War II. Now, its mission has expanded to fight...

. The system was a monetary order intended to govern currency relations among sovereign states, with the 44 member countries required to establish a parity of their national currencies in terms of the U.S. dollar and to maintain exchange rates within 1% of parity (a "band

Band of fluctuation

Band of fluctuation is the range within which the market value of a national currency is permitted to fluctuate by international agreements, or by unilateral decision by the central bank....

") by intervening in their foreign exchange market

Foreign exchange market

The foreign exchange market is a global, worldwide decentralized financial market for trading currencies. Financial centers around the world function as anchors of trading between a wide range of different types of buyers and sellers around the clock, with the exception of weekends...

s (that is, buying or selling foreign money). The U.S. dollar was the only currency strong enough to meet the rising demands for international currency transactions, and so United States agreed both to link the dollar to gold at the rate of $35 per ounce of gold and to convert dollars into gold at that price.

Due to concerns about America's rapidly deteriorating payments situation and massive flight of liquid capital

Capital flight

Capital flight, in economics, occurs when assets and/or money rapidly flow out of a country, due to an economic event and that disturbs investors and causes them to lower their valuation of the assets in that country, or otherwise to lose confidence in its economic...

from the U.S., President Richard Nixon

Richard Nixon

Richard Milhous Nixon was the 37th President of the United States, serving from 1969 to 1974. The only president to resign the office, Nixon had previously served as a US representative and senator from California and as the 36th Vice President of the United States from 1953 to 1961 under...

suspended the convertibility of the dollar into gold on 15 August 1971

Nixon Shock

The Nixon Shock was a series of economic measures taken by U.S. President Richard Nixon in 1971 including unilaterally cancelling the direct convertibility of the United States dollar to gold that essentially ended the existing Bretton Woods system of international financial exchange.-Background:By...

. In December 1971, the Smithsonian Agreement

Smithsonian Agreement

The Smithsonian Agreement was a December 1971 agreement that ended the fixed exchange rates established at the Bretton Woods Conference of 1944.-History:...

paved the way for the increase in the value of the dollar price of gold from $35.50 $38 an ounce. Speculation against the dollar in March 1973 led to the birth of the independent float, thus effectively terminating the Bretton Woods system.

Current monetary regimes

Since March 1973, the floating exchange rate

Floating exchange rate

A floating exchange rate or fluctuating exchange rate is a type of exchange rate regime wherein a currency's value is allowed to fluctuate according to the foreign exchange market. A currency that uses a floating exchange rate is known as a floating currency....

has been followed and formally recognised by the Jamaica accord of 1978. Nations still need international reserves

Foreign exchange reserves

Foreign-exchange reserves in a strict sense are 'only' the foreign currency deposits and bonds held by central banks and monetary authorities. However, the term in popular usage commonly includes foreign exchange and gold, Special Drawing Rights and International Monetary Fund reserve positions...

in order to intervene in foreign exchange market

Foreign exchange market

s to balance short-run fluctuations in exchange rates.The prevailing exchange rate regime is in fact often considered as a revival of the Bretton Woods policies, namely Bretton Woods II.

Mechanism

Under this system, the central bank first announces a ﬁxed exchange-rate for the currency and then agrees to buy and sell the domestic currency at this value. The market equilibrium

Economic equilibrium

In economics, economic equilibrium is a state of the world where economic forces are balanced and in the absence of external influences the values of economic variables will not change. It is the point at which quantity demanded and quantity supplied are equal...

exchange rate is the rate at which supply and demand will be equal, i.e., markets will clear

Market clearing

In economics, market clearing refers to either# a simplifying assumption made by the new classical school that markets always go to where the quantity supplied equals the quantity demanded; or# the process of getting there via price adjustment....

. In a ﬂexible exchange rate system, this is the spot rate

Spot price

The spot price or spot rate of a commodity, a security or a currency is the price that is quoted for immediate settlement . Spot settlement is normally one or two business days from trade date...

. In a ﬁxed exchange-rate system, the pre-announced rate may not coincide with the market equilibrium exchange rate. The foreign central banks maintain reserves of foreign currencies

Foreign exchange reserves

and gold which they can sell in order to intervene in the foreign exchange market to make up the excess demand or take up the excess supply

The demand for foreign exchange is derived from the domestic demand for foreign goods, services, and financial assets. The supply of foreign exchange is similarly derived from the foreign demand for goods, services, and financial assets coming from the home country. Fixed exchange-rates are not permitted to fluctuate freely or respond to daily changes in demand and supply. The government fixes the exchange value of the currency. For example, the European Central Bank

European Central Bank

The European Central Bank is the institution of the European Union that administers the monetary policy of the 17 EU Eurozone member states. It is thus one of the world's most important central banks. The bank was established by the Treaty of Amsterdam in 1998, and is headquartered in Frankfurt,...

(ECB) may fix its exchange rate at €1 = $1 (assuming that the euro follows the fixed exchange-rate). This is the central value or par value of the euro. Upper and lower limits for the movement of the currency are imposed, beyond which variations in the exchange rate are not permitted. The "band" or "spread" in Fig.1 is €0.4 (from €1.2 to €0.8).

Excess demand for dollars

Fig.2 describes the excess demand for dollars. This is a situation where domestic demand for foreign goods, services, and financial assets exceeds the foreign demand for goods, services, and financial assets from the European Union

European Union

The European Union is an economic and political union of 27 independent member states which are located primarily in Europe. The EU traces its origins from the European Coal and Steel Community and the European Economic Community , formed by six countries in 1958...

. If the demand for dollar rises from DD to D'D', excess demand is created to the extent of cd. The ECB will sell cd dollars in exchange for euros to maintain the limit within the band. Under a floating exchange rate system, equilibrium would have been achieved at e.

When the ECB sells dollars in this manner, its official dollar reserves decline and domestic money supply

Money supply

In economics, the money supply or money stock, is the total amount of money available in an economy at a specific time. There are several ways to define "money," but standard measures usually include currency in circulation and demand deposits .Money supply data are recorded and published, usually...

shrinks. To prevent this, the ECB may purchase government bonds and thus meet the shortfall in money supply. This is called sterilized intervention

Sterilization (economics)

Sterilization in macroeconomics refers to the actions taken by a country's central bank to counter the effects on the money supply caused by a balance of payments surplus or deficit....

in the foreign exchange market.
When the ECB starts running out of reserves, it may also devalue the euro in order to reduce the excess demand for dollars, i.e., narrow the gap between the equilibrium and ﬁxed rates.

Excess supply of dollars

Fig.3 describes the excess supply of dollars. This is a situation where the foreign demand for goods, services, and financial assets from the European Union exceeds the European demand for foreign goods, services, and financial assets. If the supply of dollars rises from SS to S'S', excess supply is created to the extent of ab. The ECB will buy ab dollars in exchange for euros to maintain the limit within the band. Under a floating exchange rate system, equilibrium would again have been achieved at e.

When the ECB buys dollars in this manner, its official dollar reserves increase and domestic money supply

Money supply

expands, which may lead to inflation. To prevent this, the ECB may sell government bonds ans thus counter the rise in money supply.

When the ECB starts running out of reserves, it may also revalue the euro in order to reduce the excess supply of dollars, i.e., narrow the gap between the equilibrium and ﬁxed rates. This is the opposite of devaluation

Devaluation

Devaluation is a reduction in the value of a currency with respect to those goods, services or other monetary units with which that currency can be exchanged....

The gold standard

Under the gold standard, a country’s government declares that it will exchange its currency for a certain weight in gold. In a pure gold standard, a country’s 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 with 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. The mint parity or the exchange rate was thus:
R = $/£ = 113.0016/23.22 = 4.87.
The main argument in favour of the gold standard is that it ties the world price level to the world supply of gold, thus preventing inﬂation unless there is a gold discovery (a gold rush

Gold rush

A gold rush is a period of feverish migration of workers to an area that has had a dramatic discovery of gold. Major gold rushes took place in the 19th century in Australia, Brazil, Canada, South Africa, and the United States, while smaller gold rushes took place elsewhere.In the 19th and early...

, for example).

Price specie flow mechanism

The automatic adjustment mechanism under the gold standard is the price specie flow mechanism

Price specie flow mechanism

The price–specie flow mechanism is a logical argument by David Hume against the Mercantilist idea that a nation should strive for a positive balance of trade, or net exports...

, which operates so as to correct any balance of payments disequilibria and adjust to shocks

Shock (economics)

In economics a shock is an unexpected or unpredictable event that affects an economy, either positively or negatively. Technically, it refers to an unpredictable change in exogenous factors—that is, factors unexplained by economics—which may have an impact on endogenous economic variables.The...

or changes. This mechanism was originally introduced by Richard Cantillon

Richard Cantillon

Richard Cantillon was an Irish-French economist and author of Essai sur la Nature du Commerce en Général , a book considered by William Stanley Jevons to be the "cradle of political economy". Although little information exists on Cantillon's life, it is known that he became a successful banker and...

and later discussed by David Hume

David Hume

David Hume was a Scottish philosopher, historian, economist, and essayist, known especially for his philosophical empiricism and skepticism. He was one of the most important figures in the history of Western philosophy and the Scottish Enlightenment...

in 1752 to refute the mercantilist

Mercantilism

Mercantilism is the economic doctrine in which government control of foreign trade is of paramount importance for ensuring the prosperity and security of the state. In particular, it demands a positive balance of trade. Mercantilism dominated Western European economic policy and discourse from...

doctrines and emphasize that nations could not continuously accumulate gold by exporting more than their imports.

The assumptions of this mechanism are:

Prices are ﬂexible
All transactions take place in gold
There is a ﬁxed supply of gold in the world
Gold coins are minted at a ﬁxed parity in each country
There are no banks and no capital ﬂows

Adjustment under a gold standard involves the flow of gold between countries resulting in equalization

Equalization payments

Equalization payments are cash payments made in some federal systems of government from the federal government to subnational governments with the objective of offsetting differences in available revenue or in the cost of providing services....

of prices satisfying purchasing power parity

Purchasing power parity

In economics, purchasing power parity is a condition between countries where an amount of money has the same purchasing power in different countries. The prices of the goods between the countries would only reflect the exchange rates...

, and/or equalization of rates of return on assets satisfying interest rate parity

Interest rate parity

Interest rate parity is a no-arbitrage condition representing an equilibrium state under which investors will be indifferent to interest rates available on bank deposits in two countries. Two assumptions central to interest rate parity are capital mobility and perfect substitutability of domestic...

at the current fixed exchange rate. Under the gold standard, each country's money supply consisted of either gold or paper currency backed by gold. Money supply would hence fall in the deficit nation and rise in the surplus nation. Consequently, internal prices would fall in the deficit nation and rise in the surplus

Government budget

A government budget is a legal document that is often passed by the legislature, and approved by the chief executive-or president. For example, only certain types of revenue may be imposed and collected...

nation, making the exports of the deficit nation more competitive than those of the surplus nations. The deficit nation's exports would be encouraged and the imports would be discouraged till the deficit in the balance of payments was eliminated.

In brief:

Deficit nation: Lower money supply → Lower internal prices → More exports, less imports → Elimination of deficit

Surplus nation: Higher money supply → Higher internal prices → Less exports, more imports → Elimination of surplus

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 country’s 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

Reserve Bank of India

The Reserve Bank of India is the central banking institution of India and controls the monetary policy of the rupee as well as US$300.21 billion of currency reserves. The institution was established on 1 April 1935 during the British Raj in accordance with the provisions of the Reserve Bank of...

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.

Currency board

Currency board

A currency board is a monetary authority which is required to maintain a fixed exchange rate with a foreign currency. This policy objective requires the conventional objectives of a central bank to be subordinated to the exchange rate target....

arrangements are the most widespread means of fixed exchange rates. Under this, a nation rigidly pegs its currency to a foreign currency, Special drawing rights

Special Drawing Rights

Special Drawing Rights are supplementary foreign exchange reserve assets defined and maintained by the International Monetary Fund . Not a currency, SDRs instead represent a claim to currency held by IMF member countries for which they may be exchanged...

(SDR) or a basket of currencies. The central bank's role in the country's monetary policy is therefore minimal. CBAs have been operational in many nations like

Hong Kong (since 1983);
Argentina
Argentine Currency Board
The Argentine Currency Board pegged the Argentine peso to the U.S. dollar between 1991 and 2002 in an attempt to eliminate hyperinflation and stimulate economic growth. While it initially met with considerable success, the board's actions ultimately failed. In contrast of what most people think,...

(1991 to 2001);
Estonia (since 1992);
Lithuania (since 1994);
Bosnia and Herzogovina (since 1997);
Bulgaria (since 1997);
Bermuda (since 1972);
Denmark (since 1945);
Brunei (since 1967)

Gold exchange standard

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. 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.

Unlike the gold standard, the central bank of the reserve country does not exchange gold for currency with the general public, only with other central banks.

Hybrid exchange rate systems

The current state of foreign exchange markets does not allow for the rigid system of fixed exchange rates. At the same time, freely floating exchange rates expose a country to volatility

Volatility (finance)

In finance, volatility is a measure for variation of price of a financial instrument over time. Historic volatility is derived from time series of past market prices...

in exchange rates. Hybrid exchange rate systems have evolved in order to combine the characteristics features of fixed and flexible exchange rate systems. They allow fluctuation of the exchange rates without completely exposing the currency to the flexibility of a free float.

Basket-of-currencies

Countries often have several important trading partners or are apprehensive of a particular currency being too volatile

Volatility (finance)

In finance, volatility is a measure for variation of price of a financial instrument over time. Historic volatility is derived from time series of past market prices...

over an extended period of time. They can thus choose to peg their currency to a weighted average of several currencies (also known as a currency basket

Currency basket

A currency basket is a portfolio of selected currencies with different weightings. A currency basket is commonly used to minimize the risk of currency fluctuations. An example of a currency basket is the European Currency Unit that was used by the European Community member states as the unit of...

) . For example, a composite currency may be created consisting of hundred rupees, 100 Japanese yen and one U.S. dollar the country creating this composite would then need to maintain reserves in one or more of these currencies to satisfy excess demand or supply of its currency in the foreign exchange market.

A popular and widely used composite currency is the SDR, which is a composite currency created by the International Monetary Fund

International Monetary Fund

(IMF), consisting of a fixed quantity of U.S. dollars, euros, Japanese yen, and British pounds.

Crawling pegs

In a crawling peg system a country fixes its exchange rate to another currency or basket of currencies. This fixed rate is changed from time to time at periodic intervals with a view to eliminating exchange rate volatility to some extent without imposing the constraint of a fixed rate. Crawling pegs are adjusted gradually, thus avoiding the need for interventions

Currency intervention

Currency intervention is the buying or selling of currency by central banks in an attempt to manipulate the price of a particular currency.-Japanese Yen:From 1989 to 2003, the Japanese economy was suffering from a long deflationary period...

by the central bank (though it may still choose to so in order to maintain the fixed rate in the event of excessive fluctuations).

Pegged within a band

A currency is said to be pegged within a band when the central bank

Central bank

specifies a central exchange rate with reference to a single currency, a cooperative arrangement, or a currency composite. It also specifies a percentage allowable deviation on both sides of this central rate. Depending on the band width, the central bank has discretion in carrying out its monetary policy. The band itself may be a crawling one, which implies that the central rate is adjusted periodically. Bands may be symmetrically maintained around a crawling central parity (with the band moving in the same direction as this parity does). Alternatively, the band may be allowed to widen gradually without any pre-announced central rate.

Currency boards

A currency board (also known as 'linked exchange rate system")effectively replaces the central bank through a legislation to fix the currency to that of another country. The domestic currency remains perpetually exchangeable for the reserve currency

Reserve currency

A reserve currency, or anchor currency, is a currency that is held in significant quantities by many governments and institutions as part of their foreign exchange reserves...

at the fixed exchange rate. As the anchor currency is now the basis for movements of the domestic currency, the interest rates and inflation in the domestic economy would be greatly influenced by those of the the foreign economy to which the domestic currency is tied. The currency board needs to ensure the maintenance of adequate reserves of the anchor currency. It is a step away from officially adopting the anchor currency (termed as dollarization

Dollarization

Dollarization occurs when the inhabitants of a country use foreign currency in parallel to or instead of the domestic currency. The term is not only applied to usage of the United States dollar, but generally to the use of any foreign currency as the national currency.The biggest economies to have...

or euroization).

Dollarization/euroization

This is the most extreme and rigid manner of fixing exchange rates as it entails adopting the currency of another country in place of its own. The most prominent example is the eurozone

Eurozone

The eurozone , officially called the euro area, is an economic and monetary union of seventeen European Union member states that have adopted the euro as their common currency and sole legal tender...

, where 17 seventeen European Union

European Union

(EU) member states

Member State of the European Union

A member state of the European Union is a state that is party to treaties of the European Union and has thereby undertaken the privileges and obligations that EU membership entails. Unlike membership of an international organisation, being an EU member state places a country under binding laws in...

have adopted the euro (€) as their common currency. Their exchange rates are effectively fixed to each other.
There are similar examples of countries adopting the U.S. dollar as their domestic currency- British Virgin Islands

British Virgin Islands

The Virgin Islands, often called the British Virgin Islands , is a British overseas territory and overseas territory of the European Union, located in the Caribbean to the east of Puerto Rico. The islands make up part of the Virgin Islands archipelago, the remaining islands constituting the U.S...

, Caribbean Netherlands, East Timor, Ecuador

Ecuador

Ecuador , officially the Republic of Ecuador is a representative democratic republic in South America, bordered by Colombia on the north, Peru on the east and south, and by the Pacific Ocean to the west. It is one of only two countries in South America, along with Chile, that do not have a border...

, El Salvador, Marshall Islands

Marshall Islands

The Republic of the Marshall Islands , , is a Micronesian nation of atolls and islands in the middle of the Pacific Ocean, just west of the International Date Line and just north of the Equator. As of July 2011 the population was 67,182...

, Federated States of Micronesia, Palau

Palau

Palau , officially the Republic of Palau , is an island nation in the Pacific Ocean, east of the Philippines and south of Tokyo. In 1978, after three decades as being part of the United Nations trusteeship, Palau chose independence instead of becoming part of the Federated States of Micronesia, a...

, Panama, Turks and Caicos Islands

Turks and Caicos Islands

The Turks and Caicos Islands are a British Overseas Territory and overseas territory of the European Union consisting of two groups of tropical islands in the Caribbean, the larger Caicos Islands and the smaller Turks Islands, known for tourism and as an offshore financial centre.The Turks and...

Advantages

A fixed exchange rate may minimize instabilities in real economic activity
Central banks can acquire credibility by fixing their country's currency to that of a more disciplined nation
On a microeconomic
Microeconomics
Microeconomics is a branch of economics that studies the behavior of how the individual modern household and firms make decisions to allocate limited resources. Typically, it applies to markets where goods or services are being bought and sold...

level, a country with poorly developed or illiquid
Market liquidity
In business, economics or investment, market liquidity is an asset's ability to be sold without causing a significant movement in the price and with minimum loss of value...

money market
Money market
The money market is a component of the financial markets for assets involved in short-term borrowing and lending with original maturities of one year or shorter time frames. Trading in the money markets involves Treasury bills, commercial paper, bankers' acceptances, certificates of deposit,...

s may fix their exchange rates to provide its residents with a synthetic money market with the liquidity of the markets of the country that provides the vehicle currency
A fixed exchange rate reduces volatility and fluctuations in relative prices
It eliminates exchange rate risk
Currency risk
Currency risk or exchange rate risk is a form of financial risk that arises from the potential change in the exchange rate of one currency in relation to another...

by reducing the associated uncertainty
It imposes discipline on the monetary authority
International trade and investment ﬂows between countries are facilitated
Speculation
Speculation
In finance, speculation is a financial action that does not promise safety of the initial investment along with the return on the principal sum...

in the currency markets is likely to be less destabilizing under a fixed exchange rate system than it is in a flexible one, since it does not amplify fluctuations resulting from business cycles
Fixed exchange rates impose a price discipline on nations with higher inflation rates than the rest of the world, as such a nation is likely to face persistent deficits in its balance of payments
Balance of payments
Balance of payments accounts are an accounting record of all monetary transactions between a country and the rest of the world.These transactions include payments for the country's exports and imports of goods, services, financial capital, and financial transfers...

and loss of reserves

Disadvantages

The need for a fixed exchange rate regime is challenged by the emergence of sophisticated derivatives and financial tools in recent years, which allow ﬁrms to hedge
Hedge (finance)
A hedge is an investment position intended to offset potential losses that may be incurred by a companion investment.A hedge can be constructed from many types of financial instruments, including stocks, exchange-traded funds, insurance, forward contracts, swaps, options, many types of...

exchange rate ﬂuctuations
Currency risk
Currency risk or exchange rate risk is a form of financial risk that arises from the potential change in the exchange rate of one currency in relation to another...
The announced exchange rate may not coincide with the market equilibrium exchange rate, thus leading to excess demand or excess supply
The central bank needs to hold stocks of both foreign and domestic currencies at all times in order to adjust and maintain exchange rates and absorb the excess demand or supply
Fixed exchange rate does not allow for automatic correction of imbalances in the nation's balance of payments since the currency cannot appreciate/depreciate as dictated by the market
It fails to identify the degree of comparative advantage
Comparative advantage
In economics, the law of comparative advantage says that two countries will both gain from trade if, in the absence of trade, they have different relative costs for producing the same goods...

or disadvantage of the nation and may lead to inefficient allocation of resources throughout the world
There exists the possibility of policy delays and mistakes in achieving external balance
The cost of government intervention is imposed upon the foreign exchange market

External links

http://internationalecon.com/Finance/Fch80/F80-1.php
http://eh.net/encyclopedia/article/redish.bimetallism

News articles

http://www.washingtonpost.com/wp-dyn/content/article/2005/07/26/AR2005072600681.html
http://www.forexrealm.com/forex-analytics/exchange-rates/exchange-rate-regimes.html
http://www.gold-eagle.com/greenspan011098.html
http://www.washingtonpost.com/wp-dyn/content/article/2005/07/21/AR2005072100351.html

The source of this article is wikipedia, the free encyclopedia. The text of this article is licensed under the GFDL.

History

Chronology

Gold standard

Bretton Woods system

Current monetary regimes

Mechanism

Excess demand for dollars

Excess supply of dollars

The gold standard

Price specie flow mechanism

Reserve currency standard

Gold exchange standard

Hybrid exchange rate systems

Basket-of-currencies

Crawling pegs

Pegged within a band

Currency boards

Dollarization/euroization

Advantages

Disadvantages

See also

External links

Further reading

News articles