Pegged and Fixed Exchange Rate Systems, Essay Example

The value of a nation’s currency essentially determines its financial strength relative to its neighbours and trading partners. As such, the valuation of a given currency against another directly and indirectly influences the amount and level of trade that both countries can engage in. The foreign exchange market allows for economies to conduct trade and exchange of their currencies based on a given rate that is either predetermined, managed or open to market forces. The exchange rate system adopted by a given economy reflects their economic interests relative to the external market. There are generally four exchange rate systems that can be adopted; (1) free floating exchange rates, (2) managed floating exchange rates, (3) semi-fixed exchange rates / pegged but adjustable exchange rates, and (4) fixed exchange rates. While most economies adopt the free floating, the semi-fixed and fixed exchange rates have in the past attracted discourse. There are inherent differences between the pegged but adjustable and the fixed exchange rate systems.

Fixed Exchange Rate System

This form of exchange rate system adopts a fixed rate of exchange between a given set of currencies. This rate of exchange is determined by the government or the central bank, working for the government, and is known as official parity. In order to achieve this parity, the central bank can fix the nation’s currency relative to another measure of value, another currency or a basket of currencies. One of the most common and earliest forms of a fixed exchange rate was the use of the gold standard. The gold standard was fundamentally the valuation of currency in terms of gold. This depended on a predetermined rate at which one can exchange ounces of gold to their currency.

This type of exchange rate system is usually employed to bring stability to a volatile currency. This is achieved by directly fixing the currency in question with that of another currency that depicts a more stable exchange rate (Krugman 63). This has the advantage of easing trade between the economies that have opted to fix their currencies relative to each other. This is also helpful in mitigating inflation while ensuring the government can only employ external monetary policy to realize macroeconomic stability.

The gold standard fundamentally limited an economy’s liquidity to its national stocks of gold or the amount of cash within its deposits that could be exchanged into gold. This created a considerable disparity between developed and underdeveloped economies, as developed economies had the ability to acquire deposits to fill their central bank gold deposit.

Pegged Exchange Rate System

The pegged but adjustable exchange rate system is a compromise between the fixed exchange rate system and the free floating exchange rate system. This system, in its creation, aims at realizing the benefits of both systems while mitigating the negative implications of employing either system in solitarily (Ugeux 26). The pegged system essentially improves on the fixed gold standard system by allowing for little room for fluctuation of the value of the currency.

This exchange rate system entails the determination of a target rate, ideally the optimal value that would allow for elimination of any fundamental disequilibrium within the balance of payments. When the target rate is set by the central bank, it is pegged to another country’s currency. This currency is usually that of its main trading partner either in terms of good and services or financial services us loans and investment. This allows facilitates fluidity in trade, increasing efficiencies and mitigating external payments constraints. It is the duty of the central bank to stabilize their pegged rate at all times. As such, the central bank has to hold considerable reserves of the foreign currency to be able to control the forces of demand and supply that may work against their set objectives. In cases where demand for the foreign currency increases, the exchange rate increases. To control this, the central bank would release some of the foreign currency within its reserves to meet demand and bring down the exchange rates. The central bank would buy up more of the foreign currency when the demand is low. Low demand would drive down the exchange rates.

This system has one underlying potential risk. Owing to the nature of the system, there has to exist a superior and stable currency as well as an inferior and potentially unstable currency. The inferior currency is usually a developing country while the superior one a developed country. If the superior country does not effectively manage its pegged rate, there is a possibility they will end up with worthless currency. This can take place when other nations realize that theircurrency is not worth as much as its pegged rate. This may cause these nations to exchange that currency for a more stable one. This increase in supply of their currency would drive down the exchange rates, leading to economic collapse.

The Bretton Wood System

After the Second World War, there was an increasing need to reconstruct economies that had been destroyed by the war. To achieve this, an international monetary regime dubbed the Bretton Wood System was developed. This system was the compromise of the classical gold standard and the free floating exchange that had prevailed before and during the war.

There was a consensus that the free floating exchange rate system was found to be highly risky, especially experienced during the war. Volatile market forces caused the decline of economies. However, most economies would not adopt the classical gold standards that embodied a fixed exchange rate system (Isaak and Hankel 62).Economists and policy makers unanimously agreed that there was an increasing need to revise the value of currencies when need warranted.

Members of the conference developed an adjustable peg or pegged rate currency regime that required all member states to declare the peg for their currency. Furthermore, they were to maintain this peg so as to mitigate the fluctuations from the agreed peg rate. These were defined by maximum margined called “bands”. All members reserved the right to revalue their peg rate in the case where fundamental disequilibrium were experienced in theirbalance of payments.

In order to assure members of an adequate supply of monetary reserves, their liquidity would be determined by their gold deposits within their central banks and any other currencies that can be converted into gold through the gold exchange standards that had existed before the war. Therefore, the United States, whose gold deposits was 75% of its central bank deposits was highly favoured (Bordo and Eichengreen). Members’ were required to employ free multilateral payments with no exchange regulation. This system was to be managed and controlled by the IMF.

After the first two years, The IMF was not sufficient to adequately fulfil its functions owing to limited deposits. As such, the United States was the only country to undertake the responsibility of using its own currency to finance deposits. This made the dollar as the globally preferred currency for payments and trade.

European Exchange Rate System

This system’s design bears resemblance to the Bretton Wood System. This system was introduced in Europe in a bid to mitigate the variability of the exchange rates within Europe. This was meant to pave way for the introduction of the Euro, a single currency for the Euro Zone. This system was founded on the ideology of fixing a target rate allowing for marginswithin which the par value can fluctuate (Heinelt 44). A parity grid was created to determine the exchange rates of each individual currency, expressed in European Currency Units.

In conclusion, both the European Exchange Rate System and Bretton Wood System were founded on the pegged but adjustable exchange rate system. While this system embodied the benefits of stability of a fixed exchange rate and the adjustability of a free floating exchange system, they both failed. This system relies on the ideology of one common economic goal by all member states. However, each state seeks to realize economic superiority. Managing a system with numerous .interest and varying economic needs is difficult, if not near impossible.

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