Practice Exam Questions
Fixed Exchange Rates - Chain of Reasoning
- A-Level, IB
- AQA, Edexcel, OCR, IB, Eduqas, WJEC
Last updated 24 Nov 2022
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
- 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.
- 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.