# Fixed exchange rates

In this video we’ll examine fixed exchangerates and see how they are managed.

You should have a basic understanding of exchangerates and understand how they are determined.

I’ll make a couple of points regarding thisin the presentation.

Fixed exchange rate systems occur when thegovernment of a country fixes the value of its currency to another currency, a basketof currencies or a commodity, such as gold.

I’ve put the image up of the Bahamas becausemany Caribbean islands peg, or fix, the value of their currency against the American dollarbecause they are heavily dependent on the US for tourism.

A government operating a fixed exchange rateregime will intervene in the foreign exchange market or use the interest rate to influencethe supply and demand for the currency.

We’ll define what happens when they aimto increase or decrease the value of the currency in the next slide.

We’ll then look at how it’s done.

When discussing the revaluation or devaluationof currencies, we are generally referring to fixed exchange rate regimes.

Revaluation occurs when a government intervenesto increase the value of its currency relative to another.

If a country sets its exchange rate to 2 to1 against the dollar and then allows it to increase to 1 to 1, then we say that it hasrevalued.

Devaluation occurs when a government intervenesto decrease the value of its currency relative to another.

If a country sets its exchange rate to 1 to1 against the dollar and then allows it to decrease to 2 to 1, then we say that it hasdevalued.

Next we’ll see how a government activelyintervenes to keep the exchange rate fixed.

Although China no longer operates a fixedexchange rate regime, having moved over to a managed float system, we can actually usethe country’s currency history to help us understand the two different exchange ratesystems.

For this example, we will look at the periodof time in which China fixed the value of the yuan to the dollar at about 8.

28 to thedollar.

This value held from 1994 to 2005.

How it’s changed since we will look at inthe next video.

Imagine that the Chinese government wantsto keep the value of the currency at ER* relative to the dollar.

28 yuan, then we know that 1yuan =.

1 cents.

I arrived at this figure by dividing \$1 by8.

28.

Suppose the demand for Chinese exports risessignificantly and the yuan starts to strengthen against the dollar.

This would make Chinese exports more expensiveto American buyers and could potentially hurt the export-led growth and development theChinese government pursued during that time frame.

So, in order to maintain stability in exportmarkets, the Chinese government would intervene by increasing the supply of yuan in the foreignexchange market.

This would decrease the value of the currencyand it would return it to its original exchange rate with the United States dollar.

The government essentially takes actions tooffset any increase or decrease in the exchange rate.

If it wants to decrease the exchange rate,it sells off its own currency or the central bank takes action to decrease interest rates.

If it aims to increase the exchange rate,the government could buy its own currency, limit how much can be exchanged in the foreignexchange market, or the central bank could choose to increase interest rates.

The advantages of a fixed exchange rate systeminclude the reduction in risk which is associated with exchange rate fluctuations.

Firms know what exchange rate to expect whenconducting business abroad and this can inform more long-term decision making.

Also, with a fixed exchange rate system, currencyspeculation is limited.

If there is an expectation that the currencymay be revalued or devalued, there’s still the possibility of speculation.

However, a fixed exchange rate regime is farless prone to speculation than a floating exchange rate system.

The disadvantages of operating a fixed exchangerate regime include a loss of flexibility in responding to economic conditions.

If the government chooses to decrease interestrates to increase aggregate demand within the economy, it must also consider the resultingimpact on the exchange rate.

In order to manage the value of their currency,a government may have to hold foreign currency reserves.

Since they must hold reserves, there is anassociated opportunity cost in that these reserves cannot be used for other purposes,such as investment.

If the central bank is changing interest ratesto change the value of the exchange rate, this will also have an impact on the domesticeconomy.

Changing interest rates also affect consumerand business behaviour by increasing the cost of borrowing.

Hopefully you’ve got a better understandingof fixed exchange rates and fixed exchange rate regimes.

If you have any questions, please leave thembelow or email me at enhancetuition@gmail.

Com.

You can also tweet me @enhancetuition andsoon find me on my website enhancetuition.

Co.

Uk.

As always, thanks for watching and I willsee you in the next one!.