EXCHANGE RATE

Fixed Exchange Rate

Abstract

If a country fixes or “pegs” the exchange rate at a target level, the exchange rate cannot move to equate the demand and supply of the currencies traded on the foreign exchange market, resulting in an excess demand or an excess supply of the foreign currency, which the country's central bank must satisfy to maintain the peg.In this paper we try to focus on the fixed exchange rate. The paper will discuss the fixed exchange rate from the perspective of a Canadian case. In the rest of the world, countries adopt various policies aimed at limiting exchange rate movements. These range from fixed exchange rate policies, wherein a government announces a fixed price of one unit of a target currency such as the dollar or the euro in terms of its currency, to allowing exchange rates to move over time but in a limited fashion.

Table of Contents

Abstract2

Introduction4

Discussion4

Canadian Case6

Conclusion7

References8

Fixed Exchange Rate

Introduction

Under fixed exchange rates with perfect capital mobility, monetary policy has no effect on the level of output or on interest rates, but fiscal policy is very powerful in changing the level of output. Similarly, other shocks to aggregate demand, such as autonomous changes in investment or consumption, also have large output effects. Under fixed exchange rates, devaluation (revaluation) of home currency raises (lowers) domestic output. The intuition behind many of these results is straightforward. Monetary policy loses power to affect output under fixed rates because it must be directed at keeping the exchange rate fixed (Obstfeld, 1995).

Discussion

Over the past 150 years, the world has seen two extended intervals when countries followed fixed exchange rate policies. The first of these was known as the gold standard; it prevailed from about 1870 to the start of World War I in 1914 and then was revived for a few years in the late 1920s. Individual countries set fixed prices of gold in terms of their currencies and then took actions to maintain those prices. Because all of the currencies in the system were fixed to gold, they were also fixed to each other. Virtually every major country and many of the then developing countries in the world participated in this system, so that fixed exchange rate prevailed worldwide (Edwards, 1989).

The second period of fixed exchange rates was known as the Bretton Woods system. The Bretton Woods era lasted from 1946 to early 1973. This system was administered in part by the International Monetary Fund (IMF). IMF member countries declared par values for the dollar in terms of their currencies and took steps to maintain those values. In the process, each country's currency was linked to all others in the system.

In both cases, the worldwide system of fixed rates collapsed as individual countries came under pressure to change their exchange rates. Depending on the country and the era, fixed exchange rate policies were replaced by a variety of alternative policies, including floating rates or managed floats. Some countries have continued to fix the value of their currency in terms of ...