Fixed Exchange Rate Systems (AQA A Level Economics)

Introduction to Fixed Exchange Rates

• A system in which the country’s Central Bank intervenes in the currency market to fix (peg) the exchange rate in relation to another currency e.g US$
  

  • When they want their currency to appreciate, they buy it on forex markets using their foreign reserves, thus increasing its demand

  • When they want their currency to depreciate, they sell it on forex markets, thus increasing its supply
    

• Sometimes the peg is at parity, e.g. 1 Brunei Dollar = 1 Singapore Dollar

• Often the peg is not at parity, e.g. Hong Kong has pegged its currency to the US$ at a rate of HK$ 7.75 = US$ 1

• A revaluation occurs if the Central Bank decides to change the peg and increase the strength of its currency

• A devaluation occurs if the Central Bank decides to change the peg and decrease the strength of its currency
  

Diagram: Market for Hong Kong Dollar and Market for US Dollar

The Hong Kong Monetary Authority intervenes to maintain the exchange rate of HK$ 7.75 = US$ 1

Diagram analysis

• The HK$/US$ market is shown by two market diagrams: one for the HK$ market on the left and one for the US$ market on the right

• The initial exchange rate equilibrium is found at HK$ 7.75 = US$ 1, represented by point 1

• When Hong Kong firms import goods from the USA, they demand US$ to pay for them and supply HK$

• This impacts the market for each currency: the US$ appreciates and the HK$ depreciates

• To maintain the fixed exchange rate at HK$ 7.75 = US$ 1, the Hong Kong Monetary Authority intervenes in the forex market by using US$ from its foreign reserves to buy HK$

Left diagram - HK$

• The increased supply of the HK$ shifts the supply curve to the right, which results in the value of the HK$ depreciating from (HK$7.75 = $1) → (HK$7.75 = $0.97)  and a new market equilibrium forms at point 2

• The Monetary Authority intervenes by buying HK$, which shifts the demand curve right from D₁ → D₂

• The HK$ has now been moved back to its target value of K$ 7.75 = US$ 1 - point 3

Right diagram - US$

• The increased demand for the US$ shifts the demand curve to the right, which results in the value of the US$ appreciating from ($1 = HK$7.75) → ($1 = HK$7.98)  and a new market equilibrium forms at point 2

• The Monetary Authority intervenes by buying HK$ using UD$, which increases their supply shifting the supply curve right from S₁ → S₂

• The HK$ has now been moved back to its target value of K$ 7.75 = US$ 1 - point 

Evaluating Fixed Exchange Rate Systems

• A fixed exchange rate system offers stability, reduces speculative activities, but limits monetary policy autonomy
   

The Advantages & Disadvantages of a Fixed Exchange Rate System