Fixed Exchange-Rate Regime

A fixed exchange-rate regime is one in which the monetary authority maintains its currency at a declared value against another currency or a basket. It does so mainly through foreign-exchange intervention and supporting monetary or capital-account measures. The regime therefore makes exchange-rate stability a policy commitment that can constrain domestic interest-rate and liquidity decisions.

How the constraint operates

When capital is mobile, a monetary-policy change that conflicts with the peg creates capital flows and pressure on the exchange rate.

• Monetary easing can cause capital outflows and depreciation pressure. To defend the peg, the central bank sells foreign-exchange reserves, which withdraws domestic liquidity and partly reverses the easing.
• Monetary tightening can attract inflows and appreciation pressure. The central bank then buys foreign currency, adding domestic liquidity and weakening the intended tightening.
• A smaller economy pegged to a larger partner consequently tends to import the anchor country's monetary conditions.

The impossible trinity

The impossible trinity, or monetary-policy trilemma, states that an economy cannot simultaneously maintain a fixed exchange rate, free capital mobility and independent monetary policy. It can sustainably pursue only two of these three objectives.

• With a fixed rate and high capital mobility, domestic monetary conditions must remain broadly consistent with those of the anchor country.
• Independent responses to domestic inflation, recession or financial stress become more difficult because the central bank must also defend the peg.

Why the loss of autonomy is not absolute

The extent of the constraint depends on the design of the regime and the openness of the capital account.

• Capital controls can provide greater room for independent interest-rate and liquidity policies.
• A currency band or adjustable peg offers more flexibility than a rigid, permanently fixed parity.
• Sterilized intervention can offset the domestic liquidity effect of foreign-exchange intervention for a time, but persistent pressure can make such intervention costly or ineffective.
• A fixed rate may provide a nominal anchor and policy credibility, but this benefit is obtained by limiting exchange-rate and monetary flexibility.