4.5.4—Fixed exchange rates

Under a fixed exchange rate the central bank announces a target and buys or sells foreign currency to keep the market rate near it. To defend a weak currency it may sell reserves or raise interest rates; to resist appreciation it may buy foreign currency.

A peg can reduce uncertainty for traders, but reserves are finite and the policy may conflict with domestic objectives. If the target is inconsistent with fundamentals, speculation can force a devaluation or abandonment.

Devaluation is an official reduction of a fixed target; revaluation is an official increase, unlike market depreciation/appreciation. In the diagram, if the target lies above market equilibrium, excess currency supply puts downward pressure on the rate, so the central bank buys domestic currency using foreign reserves (and may raise interest rates). If the target lies below equilibrium, excess demand puts upward pressure on it, so the bank sells domestic currency and accumulates reserves. Label the target line, shortage or surplus and intervention direction.