What the Riyal, Lev, and Krone All Have in Common (2024)

A fixedexchange rateis when a country ties the value of its currency to some other widely-usedcommodityor currency. The dollar is used for most transactions ininternational trade. Today, most fixed exchange rates are pegged to theU.S. dollar. Countries also fix their currencies to that of their most frequent trading partners.

Brief History and Definition

In the past, currencies were fixed to an ounce of gold. In the1944 Bretton Woods Agreement, countries agreed to peg all currencies to the U.S. dollar. The United States agreed to redeem all dollars for gold. In 1971,President Nixontook the dollar off of thegold standardto end the recession. Nixon's action ended the 100-yearhistory of the gold standard. Still, many countries kept their currenciespegged to the dollar, because the dollar is theworld's reserve currency.

A fixed exchange rate tells you that you can always exchange your money in one currency for the same amount of another currency.Itallows you to determine how much of one currency you can trade for another. For example, if you go to Saudi Arabia, you always know a dollar will buy you 3.75 Saudi riyals, sincethe dollar's exchange ratein riyals is fixed. Saudi Arabia did that because its primary export, oil, is priced in U.S. dollars. All oil contractsand most commodities contracts around the worldare 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 toforeign direct investors. They don't have to protect themselves from wild swings in the currency's value. They arehedgingtheir currency risk.

A country can avoid inflation if it fixes its currency to a popular one like the U.S. dollar oreuro. It benefits from the strength of that country's economy. As the United States orEuropean Uniongrows, its currency does as well. Without that fixed exchange rate, the smaller country's currency will slide. As a result, the imports from the large economy become more expensive. That imports inflation, as well as goods.

For example, the U.S.dollar's valueis 3.75 Saudi riyals. If the dollar strengthens 20%against the euro, the value of the riyal, which is fixed to the dollar, has also risen 20% against the euro. To purchase French pastries, the Saudis pay less than they did before thedollar strengthened. For this reason, the Saudis didn't need to limitsupplyas oil prices fell to $50 a barrel in 2014.The value of moneyis what it purchases for you. If most of your country's imports are to a single country, then a fixed exchange rate in that currency will stabilize prices.

One country that is loosening its fixed exchange rateisChina. It ties the value of its currency, theyuan, to a basket of currencies that includes the dollar. In August 2015, it allowed the fixed rate to vary according to the prior day's closing rate. It keeps the yuan in a tight 2%trading range around that value.

China has to manually adjust theexchange rate of the yuan to the dollar. This is advantageous to China, but not for the U.S. That's why the U.S. government has pressured the Chinese government to let the yuan rise in value. That action would effectively make U.S. exports cheaper in China, while Chinese exports would be more expensive in the U.S. In other words, it's an attempt by the U.S. to lower itstrade deficit with China.

Disadvantages

A fixed exchange rate can be expensive to maintain. A country must have enoughforeign exchange reservesto manage its currency's value.

A fixed exchange rate can make a country's currency atarget for speculators. They can short the currency, artificially driving its value down. That forces the country's central bank to convert its foreign exchange, so it can prop up its currency's value. If it doesn't have enough foreign currency on hand, it will have to raise interest rates. That will cause a recession.

That happened to the British pound in 1992. The pound was pegged to Germany's mark, but Britain had higher inflation than Germany, and the already-high interest rates in the UK left its central bank with little wiggle room to adjust for inflation differences. George Soros kept shorting the pound until the U.K. central bank gave in and allowed the pound to float. In 2015, 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 against a single currency. Alternatively, many countries fix a set value to a basket of currencies, instead of just one currency. Other countries peg it to either a single currency or to a basket of currencies, but then allow it to fluctuate within a range of the pegged currency. Here are examples of each type.

Currencies fixed at a set value to a single currency: These are the nations that promise to always give the same amount in their currency for each unit of currency to which it is fixed. The list is based on a report released in April 2019 by the International Monetary Fund.