Fixed Exchange Rates
If a country treats the market for foreign exchange
as any other market, allowing the marketplace determine the price of
foreign money, it has a system of floating exchange rates.
This is what most of the Western world has had since the 1970s.
However, governments have often fixed prices in this market.1
In doing so they simultaneously establish price floors and price
ceilings--they will neither let the price rise nor fall (except within
a small range).
There are two ways a government can keep exchange rates
fixed. One method, which has been common in less-developed nations, is
called a fixed and unconvertible exchange rate
because the exchange rate is fixed, but domestic currency cannot be
freely converted into foreign money. Governments using it almost always
set the price of foreign exchange below the market-clearing price
(which means that they price their own currency too high), and thereby
cause a shortage of foreign money. The government prevents the market
from increasing price to eliminate this shortage by outlawing private
transactions in foreign exchange and requiring citizens who obtain
foreign exchange to sell it to the government. Because the government
becomes the only legal source of foreign money, those who want to buy
products from abroad must obtain those funds from the government, which
rations these funds to those purposes it deems most worthy. Although
this system is hard to justify on economic grounds and is often evaded
with extensive black-marketing, the system gives rulers a powerful tool
to reward friends and punish enemies. We will not discuss this system
The second method is a fixed and convertible
exchange rate. With this method a government does not abolish
the private market for foreign exchange, but fixes exchange rates by
standing ready to absorb any surpluses or to fill any shortages. During
the 1950s and most of the 1960s, for example, the United States pegged
the dollar to gold ($35.00 was equal to one ounce of gold), and most
other countries had pegged their currencies to the dollar (the German
Mark was fixed at four marks equal to one dollar for much of this
time). The U.S. government would buy or sell gold at $35.00 per ounce
to foreign governments on demand, and the German government would buy
and sell dollars at a price of four marks per dollar.
Supply and demand analysis tells us that if the price of
foreign exchange is set above the market-clearing price, there will be
a surplus of foreign exchange (and a shortage of the domestic
currency). At this price people will want to sell more foreign exchange
than they want to buy. The government can prevent this surplus from
lowering price by stepping into the market and buying the excess
foreign exchange. On the other hand, if the price that the government
sets is below the market-clearing price, there will be a shortage of
foreign exchange called a balance of payments deficit.
The government can prevent the shortage from raising price by selling
foreign exchange into the market. The government can obtain this
foreign exchange from reserves it stored up when there was a surplus,
or by borrowing from other countries, or by selling assets such as
gold. It should be obvious that a government can only fill a balance of
payments shortage temporarily and that if it runs for too long, the
country will run out of foreign exchange to provide to the market.
to estimate the size of the shortage or surplus of foreign
exchange when countries fixed exchange rates was once of considerable
importance, but no longer is now that most of the industrial world has
floating exchange rates.
1 Whether governments float or peg the exchange rates matters in macroeconomics
because it influences the way in which the market for foreign exchange
transmits disturbances from one sector to another. In particular, the
decision by a government to peg or float exchange rates greatly
influences the effects
of government policy
actions on the economy.
Copyright Robert Schenk