Fixed Exchange Rates - Chain of Reasoning

In this short revision video we walk through an example of a chain of analytical reasoning on this question. Analyse why a fixed exchange rate could cause difficulties for a country that has one.

The decision of a country as to which currency system to use is one of the most important they can make. Denmark for example maintains a fixed exchange rate against the Euro whereas Poland operates a floating exchange rate although both countries are inside the European Single Market.

The advantages and disadvantages of different currency systems (free floating, managed float, semi-fixed and fully-fixed) feature quite often on A-Level and IB exams

Analyse why a fixed exchange rate could cause difficulties for a country that has one.

• A fixed exchange rate is set by a government and managed by a central bank.
• It is not set by market forces of supply and demand. A good example is the fixed rate between the Danish Krone and the Euro.
• With a fixed exchange rate, the central bank must set monetary policy interest rates and be prepared to use foreign exchange reserves to maintain the currency peg
  
• One difficulty of a fixed exchange rate is that the domestic economy might be experiencing a slowdown or recession perhaps due to an external shock
• The central bank might want to cut interest rates to stimulate the money supply and aggregate demand
• But they might not be able to do this because it would then cause an outflow of hot money and put pressure on the fixed currency rate.
• A consequence can be a deeper recession than if a country was running a floating exchange rate

Evaluation

1. Countries with a fixed exchange rate can decide to devalue their exchange rate to improve competitiveness and stimulate the economy. This does carry economic risks however.
   
   
2. Although interest rates are clearly tied to maintaining a fixed exchange rate, the government can still use fiscal policy to manage aggregate demand and short run economic growth.