Fixed Exchange Rates

• Fixed exchange rate

  Exchange rate determined and maintained by government/central bank intervention, not market forces
• Floating exchange rate


  Exchange rate determined by market forces of supply and demand, with no government manipulation
• Maintaining a fixed exchange rate

  1. Government/central bank holds large domestic and foreign currency reserves

  2. Uses reserves to buy/sell domestic currency to manipulate supply and demand

  3. Aims to keep exchange rate at target level
• Pound exchange rate is overvalued compared to fixed rate

  Government sells pounds, buys foreign currency to increase pound supply and reduce exchange rate
• Pound exchange rate is undervalued compared to fixed rate


  Government buys pounds, using foreign currency reserves, to increase pound demand and raise exchange rate
• Devaluation


  Lowering the fixed exchange rate, e.g. £1 = $140 instead of £1 = $150
• Revaluation


  Increasing the fixed exchange rate, e.g. £1 = $160 instead of £1 = $150
• Interest rate changes can also be used to influence fixed exchange rates, but are less direct and have greater side effects
• Governments/central banks prefer to use currency reserves to directly buy/sell domestic currency to maintain fixed exchange rates