What is Fixed Exchange Rate System?

Under this system, the exchange rate for the currency is fixed by the government. Thus, the government is responsible to maintain the stability of the exchange rate. Each country maintains the value of its currency in terms of some ‘external standard’ like gold, silver, another precious metal, or another country’s currency. 

• The main purpose of a fixed exchange rate is to maintain stability in the country’s foreign trade and capital flows.
• The central bank or government purchases foreign exchange when the rate of foreign currency rises and sells foreign exchange when the rates fall to maintain the stability of the exchange rate.
• Thus, the government has to maintain large reserves of foreign currencies to maintain a fixed exchange rate.
• When the value of one currency(domestic) is tied to another currency then this process is known as pegging and that&#x2019s why the fixed exchange rate system is also referred to as the Pegged Exchange Rate System.
• When the value of one currency(domestic) is fixed in terms of another currency or in terms of gold, then it is called the Parity Value of currency.

Methods of Fixed Exchange Rate in Earlier Times

1. Gold Standard System (1870-1914): As per this system, gold was taken as the common unit of parity between the currencies of different countries. Each country defines the value of its currency in terms of gold. Accordingly, the value of one currency is fixed in terms of another country’s currency after considering the gold value of each currency.

For example,

1£(UK Pound)= 5g of gold

1$(US Dollar)= 2g of gold

Then the exchange rate would be £1(UK Pound) = $2.5(US Dollar)

2. Bretton Woods System (1944-1971): The gold standard system was replaced by the Bretton Woods System. This system was adopted to have clarity in the system. Even in the fixed exchange rate, it allowed some adjustments, thus it is called the ‘adjusted peg system of exchange rate’. Under this system:

• Countries were required to fix their currency against the US Dollar($).
• US Dollar was assigned gold value at a fixed price.
• The value of one currency, say £(UK Pound) was pegged in terms of the US Dollar($), which ultimately implies the value of the currency in gold.
• Gold was considered an ultimate unit of parity.
• International Monetary Fund (IMF) worked as a central institution in controlling this system.

This is the system that was abandoned and replaced by the Flexible Exchange rate in 1977.

Devaluation and Revaluation

Devaluation includes a reduction in the value of the domestic currency in terms of foreign currencies by the government. Under a fixed exchange rate system, the government undertakes devaluation when the exchange rate is increased. 

Revaluation refers to an increase in the value of the domestic currency by the government. 

Difference between Devaluation and Depreciation

A medium of exchange for goods and services is called currency, which is different from one country to another country. However, a country&#x2019s currency cannot be used in another country. For this purpose, the currency of one country is converted into the currency of another country, and the rate at which one currency is exchanged for another is called the Foreign Exchange Rate. Foreign exchange rates can be classified into various types. One of them is the Fixed Exchange Rate System. Fixed Exchange Rate System is determined by the government.