Fixed exchange rate system facts for kids

A fixed exchange rate is when a country's government or central bank decides exactly how much its money (its currency) is worth compared to another country's money, or even something like gold. Once they set this value, they promise to keep it steady. This means the central bank will buy or sell its own currency to make sure its value stays at that fixed rate.

What is a Fixed Exchange Rate?

Imagine your country's money, like the dollar or euro, has a set price against another country's money, like the Japanese yen. With a fixed exchange rate, the government or its main bank (called the central bank) decides this price and tries to keep it the same. They might say, "One dollar will always be worth 100 yen." This is different from a Floating exchange rate where the value of money changes all the time based on what people want to buy or sell.

How Does a Fixed Exchange Rate Work?

When a country uses a fixed exchange rate, its central bank has a big job. If too many people want to buy the country's money, its value might start to go up. To stop this, the central bank will sell more of its own money. If too many people want to sell the country's money, its value might start to drop. To stop this, the central bank will buy back its own money. By doing this, they keep the exchange rate stable, just like they promised.

Keeping the Rate Steady

The central bank uses its own supply of foreign money (like U.S. dollars or euros) to keep the exchange rate fixed.

• If the local currency starts to get too strong (worth too much), the central bank sells its own currency and buys foreign currency. This increases the supply of local currency and brings its value down.
• If the local currency starts to get too weak (worth too little), the central bank buys its own currency and sells foreign currency. This reduces the supply of local currency and brings its value up.

This balancing act helps keep the exchange rate fixed.

Why Do Countries Use Fixed Exchange Rates?

Countries choose fixed exchange rates for several reasons, mainly to bring stability and predictability to their economy.

Economic Stability

A fixed exchange rate can make it easier for businesses to plan. They know exactly how much money they will get when they sell goods to another country, or how much they will pay when they buy things. This can encourage more international trade and investment because there's less risk involved.

Controlling Inflation

Some countries use fixed exchange rates to help control inflation, which is when prices for goods and services go up over time. By linking their currency to a stable foreign currency, they can sometimes keep their own prices from rising too quickly. This can make people feel more confident about their money.

Challenges of Fixed Exchange Rates

While fixed exchange rates offer stability, they also come with some challenges.

Less Flexibility

When a country fixes its exchange rate, it gives up some control over its own money policy. The central bank has to focus on keeping the rate fixed, which means it might not be able to use other tools to help the economy grow or create jobs.

Vulnerability to Shocks

If the economy of the country it's linked to faces problems, the fixed-rate country can also be affected. For example, if the linked currency suddenly loses value, the fixed-rate currency might also face pressure, even if its own economy is doing well. This can sometimes lead to economic crises if the central bank runs out of foreign money to defend its fixed rate.

Related pages

• Floating exchange rate

Images for kids

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  Fig.1: Mechanism of fixed exchange-rate system

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  Fig.2: Excess demand for dollars

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  Fig.3: Excess supply of dollars

See also

In Spanish: Tipo de cambio fijo para niños