Fixed Exchange Rate: Definition, Pros, Cons, Examples

What the Riyal, Lev, and Krone All Have in Common

Man in headdress (gutra) overseeing oil retention pond,
Saudi Arabia fixes its currency to the dollar because oil is priced in dollars. Photo: Wayne Eastep/Getty Images

Definition:  A fixed exchange rate is when a country ties the value of its currency to some other widely-used commodity or currency. Today, most fixed exchange rates are pegged to the U.S. dollar. That's because the dollar is used for most transactions in international trade. Countries also fix their currencies to that of their most frequent trading partners.

In the past, currencies were fixed to the value of gold.

In the 1944 Bretton Woods Agreement, countries agreed to peg all currencies to the dollar. The United States agreed to redeem all dollars for gold. President Nixon took the dollar off of that gold standard in 1974 to end the recession. Nevertheless, many countries kept their currencies pegged to the dollar. That's because the dollar is the world's reserve currency. For more, see History of the Gold Standard.

A fixed exchange rate tells you that you can always exchange your money for the same amount of the other currency.  allow you to determine how much of one currency you can exchange for another. For example, if you go to Saudi Arabia, you know the dollar will buy you 3.75 Saudi riyals. That's because the dollar's exchange rate in riyals is fixed. Saudi Arabia did that because its primary export, oil, is priced in U.S. dollars. All oil contracts and most commodities contracts around the world are written and executed in dollars.

 

Advantages

A fixed exchange rate provides currency stability. Investors always know what the currency is worth. That makes the country's businesses attractive to foreign direct investors. They don't have to protect themselves from wild swings in the currency's value. (This is known as hedging currency risk.) 

A country can avoid inflation if it fixes its currency to a popular one like the U.S. dollar or euro. It benefits from the strength of that country's economy. As the United States or EU grows, often its currency does as well. Without that fixed exchange rate, the smaller country's currency will slide, making imports from the large economy more expensive. That effectively imports inflation. To understand this relationship, see Dollar Value.

For example, the dollar is worth 3.75 Saudi riyals. Let's say a barrel of oil is worth $100, or 375 riyals. If the dollar strengthens 20 percent against the euro, the value of the riyal, which is fixed to the dollar, has also risen 20 percent against the euro. To purchase French pastries, the Saudis can now pay less than they did before the dollar got stronger. That's why the Saudis didn't need to limit supply as oil prices fell to $50 a barrel in 2014. Find out more ways it affects you in The Value of Money.

One country that is loosening its fixed exchange rate is China. It ties the value of its currency, the yuan, to a basket of currencies including the dollar. In August, it allowed the fixed rate to vary according to yesterday's closing rate. It keeps the yuan in a tight 2 percent trading range around that value.

 For more, see Yuan to Dollar Conversion.

China has to manually adjust the exchange rate of the yuan to the dollar. That's because the U.S. government pressured the Chinese government to let the yuan rise in value. This allows U.S. exports to be more competitively priced in China. It also makes Chinese exports to the U.S. more expensive. For more on how this affects you, see U.S. China Trade Deficit.

Disadvantages

A fixed exchange rate can be expensive to maintain. A country must have enough foreign exchange reserves to manage its currency's value. 

The country's currency can become a target for speculators. They can "short" the currency, artificially driving its value down. The central bank must convert its foreign exchange to prop up its currency's value. If it doesn't have enough, it will have to raise interest rates.

That will cause a recession. (Source: "Pegs Under Pressure," The Economist, October 17, 2015.)

That happened to the British pound in 1992. George Soros kept shorting the pound until the UK central bank gave in and allowed the pound to float. In 2014, it happened when Switzerland had to release the Swiss franc from its fix to the euro, which had plummeted in value. 

Examples

There are several ways countries maintain a fixed exchange rate. The purest form is when its currency is pegged to a set value to a single currency. Many countries fix a set value to a basket of currencies. Others maintain their currency within a range. This can be fixed to either a single currency or to a basket of currencies. Here are examples of each type.

Currency Fixed at a Set Value to a Single Currency

These countries promise to always give the same amount in their currency for each unit of currency to which it is fixed. For example, the 

CountryCurrencyPeg (on 10/7/15)Fixed To:
BahamasBahamian dollar 0.99U.S. dollar
BruneiBrunei dollar 1.00Singapore dollar
BulgariaLev 1.955Euro
DenmarkKrone 7.45Euro
EgyptEgyptian pound 7.83U.S. dollar
Hong KongHong Kong dollar 7.75U.S. dollar
Saudi ArabiaRiyal 3.75U.S. dollar
VenezuelaBolivar 6.3U.S. dollar

 

Currency Loosely Fixed

CountryCurrencyBandFixed To
ChinaYuan2% trading band around yesterday's midpointBasket weighted toward U.S. dollar
Singapore  Singapore dollarManaged within trading band to allow a slow rise Basket
VietnamDong2% trading band (devalued in August 2015)U.S. dollar