Central bankers in countries with records of chronic high inflation are sometimes advised to adopt a...

Central bankers in countries with records of chronic high inflation are sometimes advised to adopt a fixed exchange rate in order to achieve creditability with their own citizens and foreign lenders. How does a fixed exchange rate enhance a central bank’s creditability? What are the potential risks of adopting a fixed exchange rate?

Expert Solution

ans
Countries prefer a fixed exchange rate regime for the purposes of export and trade. By controlling its domestic currency a country can – and will more often than not – keep its exchange rate low. This helps to support the competitiveness of its goods as they are sold abroad. it is a auto corrective mechanism, end of speculation and hedging. it encourages international trade and bring sinternal stability

But the real advantage is seen in trade relationships between countries with low costs of production (like Thailand and Vietnam) and economies with stronger comparative currencies (the United States and European Union). When Chinese and Vietnamese manufacturers translate their earnings back to their respective countries, there is an even greater amount of profit that is made through the exchange rate. So, keeping the exchange rate low ensures a domestic product's competitiveness abroad and profitability at home.

The Currency Protection Racket
The fixed exchange rate dynamic not only adds to a company's earnings outlook, it also supports a rising standard of living and overall economic growth. But that's not all. Governments that have also sided with the idea of a fixed, or pegged, exchange rate are looking to protect their domestic economies. Foreign exchange swings have been known to adversely affect an economy and its growth outlook. And, by shielding the domestic currency from volatile swings, governments can reduce the likelihood of a currency crisis.

potential risks of fixed exchange rate
There is a price that governments pay when implementing a fixed or pegged exchange rate in their countries.

A common element with all fixed or pegged foreign exchange regimes is the need to maintain the fixed exchange rate. This requires large amounts of reserves as the country's government or central bank is constantly buying or selling the domestic currency.

international crisis: international monetary crisis in the recent past has mainly been due to the system of fixed rate of exchange.

Rahul Sunny answered 2 years ago

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