Why Governments Use Fixed Currency Rates?
Most major world currencies fluctuate freely on the currency exchange market, in contrast to the so-called “pegged currencies”, which are tied to another major currency. The two common types of a fixed rate foreign exchange regime include a fixed and unconvertible exchange rate, and a fixed and convertible exchange rate. The first method of fixing the exchange rate involves a ban on the free conversion of the local currency into a foreign currency while the second one features free market for foreign exchange but fixes the exchange rates of the local currency. The pegged currencies cannot float freely on the foreign exchange market and their currency rates fluctuate in conjunction to the fluctuations of the base currency. Thus, a currency pegged to the euro will follow all moves of the single European currency on the Forex markets. Such a system offers basic protection against collapses of the currency rates of the local currency but makes it dependent on a foreign currency with all the risks related to an unexpected weakening of the base currency. Opponents of the fixed rate exchange regimes argue that they are in contradiction to the basics of the free market system, hence, they are inefficient and dangerous in times of financial crisis because such a foreign exchange regime does not provide shelter for the local currency. The free-floating currencies are more able to adjust to financial market shocks, critics insist. Another disadvantageous element of the fixed exchange rate is that the government is forced to keep large foreign exchange reserves to maintain the fixed currency rate levels. Among the advantages of the fixed foreign exchange regime is the increased confidence of the investors in the particular currency and the decreased trade and investment risks due to the lack of fluctuations in the currency rates. Theorists claim that a fixed exchange rate also suppresses inflation, which is a curse for doing business and prevents entrepreneurs from long-term planning. As a rule, the fixed exchange rate is considered a temporary measure for stabilisation of the local economy or as a tool used in preparation for major economic reforms. However, there are countries in Europe, whose currencies have been pegged for years without causing any trouble to the local economies. On the other hand, the most restrictive fixed rate foreign exchange regimes can be observed among the less economically developed nations and there is no evidence that introduction of such regulations boosted the local economies, analysts comment. The advantages and disadvantages of the free floating and fixed currency rates have been subject of debate for years but the widespread opinion is that the floating exchange rate is more advantageous for most of the developed market economies. Some experts believe that the fixed currency rate is an old-fashioned concept but it could be a useful tool if a government has no other choice but to peg its currency to a major world currency to protect their economies.