1 Explain how a country with fixed exchange rate can sustain

1. Explain how a country with fixed exchange rate can sustain an excessively strong currency longer than if it had an excessively weak currency. Based on trilemma, a country can have a fixed exchange rate and an independent monetary policy as long as it has capital controls. Explain why this is so.

Solution

A fixed exchange rate or a pegged exchange rate is a type of regime where a currency’s value is fixed against either the value of another single currency to a basket of other currencies, or to another measure of value, such as gold. This makes trade and invetments between two currency areas easier and predictable. It can be used as a means to control the behavior of currency, such as by limiting rates of inflation. The pegged currency is then controlled by its reference value. The central bank of a country typically uses an open market mechanism and is committed at all times to buy or sell its currency at a fixed price in order to maintain its pegged ratio. Hence the stable value of its currency in relation to its reference value to which it is pegged.

By controlling its domestic currency, a country can keep its exchange value low and this helps to support the competitiveness of its goods as they are sold abroad. Countries prefer fixed echange rate regime for the purpose of export and trade. It not only adds to a country’s earning outlook, but also supports a rising standard of living and overall economic growth. Governments can reduce the likelyhood of a currency crisis from foregn exchange swings by protecting the domestic currency. By pegging its currency, a country can gain comaparative trading advantages while protecting its own economic interests. The real advantage is seen in trade relationship between countries with low cost of production and economies with strong comparative advantage. When the manufacturers translate their earnings back to their respective countries, there is an even greater amount of profit through the exchange rate. Hence keping the exchange rate low ensures a domestic product’s competitiveness abroad and profitability at home.

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