Fixed Exchange Rate
Almost every sovereign nation in the world issues and controls its own currency. There are some countries which have elected to use another country's currency, primarily the United States Dollar. Sovereign currencies are the legal tender within their respective countries. The need for exchange rates between sovereign currencies has arisen as international trade has spread and flourished.
The exchange rate describes how much of one currency must be given up in order to secure a unit of another currency, for example, if you surrender one British Pound, you will receive approximately one United States Dollar and sixty cents. The exchange rate is said to be 1:1.60.
A fixed or pegged exchange rate is a currency policy enacted by a government in which its currency is matched to the value of another single currency (usually the United States Dollar) or basket of other currencies. This fixing of the currency is usually to a range of values (or band) around a central point rather than a specific fixed value point.
The policy is usually enacted to stabilize a currency and makes trade and investment between the countries easier and more predictable. This policy measure is usually employed by small economies which are highly reliant on external trade as it makes a large part of their revenues predictable. Chine is perhaps the best known country to employ a fixed exchange rate policy, though Hong Kong also has its currency pegged to the United States Dollar. It is worth noting that both of those economies are highly dependent on exports for a large percentage of their GDP (Gross Domestic Product).
Fixed exchange rates are also seen as a tool which is useful in controlling inflation but can lead to problems in an economy as the country which operates the peg effectively imports the monetary policies of the country to which its currency is pegged. The key component of this policy import is seen in the level of interest rates, which must be broadly the same in countries operating pegs as in the country to which its currency is pegged. This rate of interest may not be suitable for the country operating the peg as it may make interest rates too low (building inflationary pressures) or too high which could stifle the economy, The long term solution to these problems is a devaluation or revaluation of the pegged currency but this should be seen as an extremely infrequent event.
Fixed Exchange Rate and Gold
For many years, fixed exchange rates dominated all over the world. This is because under the gold standard, all national currencies were pegged to gold. Actually, the national currencies were defined in terms of gold ounces, so the exchange rates had to be fixed.
However, in 1971, President Nixon closed the gold window, abolishing the direct convertibility of the United States dollar into gold and finally ending the Bretton Woods system and the gold standard. That move known as the Nixon shock resulted in the free-floating of fiat currencies (although some developing countries fixed their currencies to U.S. dollar or other major currencies). This is why the price of gold surged in the 1970s – investors worried about the stability of the new monetary system based on freely fluctuating exchange rates between fiat currencies. Although this system showed some resilience over the years, it remains fragile, as the Great Recession showed. Hence, gold serves as an insurance against the current monetary system based on the fiat, freely floating U.S. dollar. The reasons behind the safe-haven properties of gold are simple: our monetary system based on the free-floating exchange rates between fiat currencies has been here only since 1971, while gold used to be money for thousands of years. Therefore, when this faith decreases, especially in the U.S. dollar, the unofficial world currency, gold prices rises.
Another link between fixed exchange rates and gold is that they can encourage the inflow of speculative capital, which may trigger a financial crisis. The best example may be the Asian financial crisis. In case of turmoil, the yellow metal may appreciate. However, fixed exchange rates are mainly used by developing countries; hence, gold, which is mainly a bet against the U.S. dollar, may not act as a hedge against a financial crisis caused or exacerbated by fixed exchange rates.
We encourage you to learn more about the gold market – not only about the link between the fixed exchange rates and the yellow metal, but also how to successfully use gold as an investment and how to profitably trade it. A great way to start is to sign up for our gold newsletter today. It's free and if you don't like it, you can easily unsubscribe.