TABLE OF CONTENTS

Introduction ............................................................................................pg 1
1. General notes about fixed exchange rates ..........................................pg 1
2. The world once pegged ......................................................................pg 2
3 Fixed versus floating exchange rates .................................................pg 3
Conclusions ............................................................................................pg 5
Bibliography ...........................................................................................pg 5

INTRODUCTION
An exchange rate is the rate at which one currency can be exchanged for another. In
other words, it is the value of another country's currency compared to that of your own. If
you are traveling to another country, you need to "buy" the local currency. Just like the
price of any asset, the exchange rate is the price at which you can buy that currency.
Theoretically, identical assets should sell at the same price in different countries, because
the exchange rate must maintain the inherent value of one currency against the other.
There are two ways the price of a currency can be determined against another.
A fixed exchange rate, sometimes (less commonly) called a pegged exchange rate, is a
rate the government (central bank) sets and maintains as the official exchange rate and is
a type of exchange rate regime wherein a currency's value is matched to the value of
another single currency or to a basket of other currencies, or to another measure of value,
such as gold. As the reference value rises and falls, so does the currency pegged to it. In
order to maintain the local exchange rate, the central bank buys and sells its own currency
on the foreign exchange market in return for the currency to which it is pegged.
A currency that uses a fixed exchange rate is known as a fixed currency. The opposite of
a fixed exchange rate is a floating exchange rate.

1. GENERAL NOTES ABOUT FIXED EXCHANGE RATES

 A currency can operate under one of four main types of exchange rate system: free
floating exchange rates, managed floating exchange rates, semi-fixed exchange rates and
fully-fixed exchange rates:
In a fixed exchange rate system, the government (or the central bank acting on the
government's behalf) intervenes in the currency market so that the exchange rate stays
close to an exchange rate target. If, for example, it is determined that the value of a single
unit of local currency is equal to USD 3.00, the central bank will have to ensure that it
can supply the market with those dollars. In order to maintain the rate, the central bank
must keep a high level of foreign reserves. This is a reserved amount of foreign currency
held by the central bank which it can use to release (or absorb) extra funds into (or out of)
the market. This ensures an appropriate money supply, appropriate fluctuations in the
market (inflation/deflation), and ultimately, the exchange rate. The central bank can also
adjust the official exchange rate when necessary.
Advantages of fixed exchange rates:
Fixed rates provide greater certainty for exporters and importers and under normally
circumstances there is less speculative activity, although this depends on whether the
dealers in the foreign exchange markets regard a given fixed exchange rate as appropriate
and credible. For example, sterling came under intensive speculative attack in the autumn
of 1992 because the markets perceived it to be overvalued and ripe for a devaluation.
Fixed exchange rates can exert a strong discipline on domestic firms and employees
to keep their costs under control in order to remain competitive in international markets.
This helps the government maintain low inflation, which in the long run should bring
interest rates down and stimulate increased trade and investment.
A classic argument for a fixed exchange rate is its promotion of trade. Empirical
support for this, however, is mixed. While one branch of research consistently shows a
small negative effect of exchange rate volatility on trade, another, more recent, branch
presents evidence of a large positive impact of currency unions on trade.

2. THE WORLD ONCE PEGGED

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 Between 1870 and 1914, there was a global fixed exchange rate. Currencies were
linked to gold, meaning that the value of a local currency was fixed at a set exchange rate
to gold ounces. This was known as the gold standard. This allowed for unrestricted
capital mobility as well as global stability in currencies and trade; however, with the start
of World War I, the gold standard was abandoned.
At the end of World War II, the conference at Bretton Woods, in an effort to generate
global economic stability and increased volumes of global trade, established the basic
rules and regulations governing international exchange. As such, an international
monetary system, embodied in the International Monetary Fund (IMF), was established
to promote foreign trade and to maintain the monetary stability of countries and therefore
that of the global economy.
It was agreed that currencies would once again be fixed, or pegged, but this time to
the U.S. dollar, which in turn was pegged to gold at USD 35/ounce. What this meant was
that the value of a currency was directly linked with the value of the U.S. dollar. For
example, if you needed to buy Japanese yen, the value of the yen would be expressed in
U.S. dollars, whose value in turn was determined in the value of gold. If a country needed
to readjust the value of its currency, it could approach the IMF to adjust the pegged value
of its currency. The peg was maintained until 1971, when the U.S. dollar could no longer
hold the value of the pegged rate of USD 35/ounce of gold.
From then on, major governments adopted a floating system, and all attempts to move
back to a global peg were eventually abandoned in 1985. Since then, no major economies
have gone back to a peg, and the use of gold as a peg has been completely abandoned.

3. FIXED VERSUS FLOATING EXCHANGE RATES

Analysts agree that "getting the exchange rate right" is essential for economic
stability and growth in developing countries. Over the past two decades, many
developing countries have shifted away from fixed exchange rates (that is, those that peg
the domestic currency to one or more foreign currencies) and moved toward more
flexible exchange rates (those that determine the external value of a currency more or less
by the market supply and demand for it).

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 The shift from fixed to more flexible exchange rates has been gradual, dating from
the breakdown of the Bretton Woods system of fixed exchange rates in the early 1970s,
when the world’s major currencies began to float. At first, most developing countries
continued to peg their exchange rates–either to a single key currency, usually the U.S.
dollar or French franc, or to a basket of currencies. By the late 1970s, they began to shift
from single currency pegs to basket pegs, such as to the IMF’s special drawing right
(SDR). Since the early 1980s, however, developing countries have shifted away from
currency pegs–toward explicitly more flexible exchange rate arrangements. This shift has
occurred in most of the world’s major geographic regions.
During a period of rapid economic growth, driven by the twin forces of globalization
and liberalization of markets and trade, this shift seems to have served a number of
countries well. But as the currency market turmoil in Southeast Asia has dramatically
demonstrated, globalization can amplify the costs of inappropriate policies. Moreover,
the challenges facing countries may change over time, suggesting a need to adapt
exchange rate policy to changing circumstances.
The overall trend is clear, though it is probably less pronounced than these figures
indicate because many countries that officially describe their exchange rate regimes as
"managed floating" or even "independently floating" in practice often continue to set
their rate unofficially or use it as a policy instrument.
Until recently, most evidence suggested that developing countries with pegged
exchange rates enjoyed relatively lower and more stable rates of inflation. In recent years,
however, many developing countries have moved toward flexible exchange rate
arrangements, at the same time as inflation has come down generally across the
developing world. Indeed, the average inflation rate for countries with flexible exchange
rates has fallen steadily, to where it is no longer significantly different from that of
countries with fixed rates.
Considerations affecting the choice of regime may change over time. When inflation
is very high, a pegged exchange rate may be the key to a successful short-run
stabilization program. Later, perhaps in response to surging capital inflows and the risk of
overheating, more flexibility is likely to be required to help relieve pressures and to
signal the possible need for adjustments to contain an external imbalance. To move

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toward full capital account convertibility, especially in a world of volatile capital flows,
flexibility may become inescapable.

CONCLUSIONS

Economists generally think that, in most circumstances, floating exchange rates are
preferable to fixed exchange rates because floating rates are responsive to the foreign
exchange market. In addition, fixed exchange rates deprive governments of the use of an
independent domestic monetary policy to achieve internal stability. However, in certain
situations, fixed exchange rates may be preferable for their greater stability.
Countries with pegs are often associated with having unsophisticated capital markets
and weak regulating institutions. The peg is therefore there to help create stability in such
an environment. It takes a stronger system as well as a mature market to maintain a float.
When a country is forced to devalue its currency, it is also required to proceed with some
form of economic reform, like implementing greater transparency, in an effort to
strengthen its financial institutions.
Countries adopting a fixed exchange rate must exercise careful and strict adherence to
policy imperatives, and keep a degree of confidence of the capital markets in the
management of such a regime, or otherwise the peg can fail.
Although the peg has worked in creating global trade and monetary stability, it was
used only at a time when all the major economies were a part of it. And while a floating
regime is not without its flaws, it has proven to be a more efficient means of determining
the long term value of a currency and creating equilibrium in the international market.

BIBLIOGRAPHY

• http://en.wikipedia.org/wiki/Fixed_exchange_rate
• http://www.investopedia.com/articles/03/020603.asp
• http://www.imf.org/external/pubs/ft/issues13/index.htm
• http://www.nber.org/papers/w10696

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• http://www.tutor2u.net/economics/content/topics/exchangerates/fixed_floating.ht
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