Fixed Exchange Rates

If a country treats the market for foreign exchange as any other market, allowing the marketplace determine the price of foreign money, it has a system of floating exchange rates. This is what most of the Western world has had since the 1970s. However, governments have often fixed prices in this market.1 In doing so they simultaneously establish price floors and price ceilings--they will neither let the price rise nor fall (except within a small range).

There are two ways a government can keep exchange rates fixed. One method, which has been common in less-developed nations, is called a fixed and unconvertible exchange rate because the exchange rate is fixed, but domestic currency cannot be freely converted into foreign money. Governments using it almost always set the price of foreign exchange below the market-clearing price (which means that they price their own currency too high), and thereby cause a shortage of foreign money. The government prevents the market from increasing price to eliminate this shortage by outlawing private transactions in foreign exchange and requiring citizens who obtain foreign exchange to sell it to the government. Because the government becomes the only legal source of foreign money, those who want to buy products from abroad must obtain those funds from the government, which rations these funds to those purposes it deems most worthy. Although this system is hard to justify on economic grounds, and is often evaded with extensive black-marketing, the system gives rulers a powerful tool to reward friends and punish enemies. We will not discuss this system further.

The second method is a fixed and convertible exchange rate. With this method a government does not abolish the private market for foreign exchange, but fixes exchange rates by standing ready to absorb any surpluses or to fill any shortages. During the 1950s and most of the 1960s, for example, the United States pegged the dollar to gold ($35.00 was equal to one ounce of gold), and most other countries had pegged their currencies to the dollar (the German Mark was fixed at four marks equal to one dollar for much of this time). The U.S. government would buy or sell gold at $35.00 per ounce to foreign governments on demand, and the German government would buy and sell dollars at a price of four marks per dollar.
Supply and demand analysis tells us that if the price of foreign exchange is set above the market-clearing price, there will be a surplus of foreign exchange (and a shortage of the domestic currency). At this price people will want to sell more foreign exchange than they want to buy. The government can prevent this surplus from lowering price by stepping into the market and buying the excess foreign exchange. On the other hand, if the price that the government sets is below the market-clearing price, there will be a shortage of foreign exchange called a balance of payments deficit. The government can prevent the shortage from raising price by selling foreign exchange into the market. The government can obtain this foreign exchange from reserves it stored up when there was a surplus, or by borrowing from other countries, or by selling assets such as gold. It should be obvious that a government can only fill a balance of payments shortage temporarily and that if it runs for too long, the country will run out of foreign exchange to provide to the market.

The attempt to estimate the size of the shortage or surplus of foreign exchange when countries fixed exchange rates was once of considerable importance, but no longer is now that most of the industrial world has floating exchange rates.