Fixed Exchange Rate in Forex Trading: Advantages and Disadvantages

Forex trading strongly relies on various external factors and news. They define the currency price movement. Traders need to take into account a variety of factors and measures the government can take to keep the economy under control. A fixed exchange rate is a measure taken by central banks to tie the official currency exchange rate to the golf price or the currency exchange rate of another country.

In this article, we will discuss how a fixed exchange rate can influence the success of your forex strategies. Also, we will learn more about the advantages and disadvantages for traders.

Fixed Exchange Rate Definition

Usually, central banks use this tool to keep the currency value in a narrower band. In economics, the fixed exchange rate is tied to the gold price or the major currency of another country. As a rule, it is not allowed to change. In other words, we the rate is $1 = €1, it will remain the same within the country until the government cancels this particular measure.

In some ways, a fixed exchange rate system can be beneficial for the country’s economy. On the other hand, forex traders will face specific obstacles and challenges on their way to successful financial management.

So, let’s have a look at the key pros and cons a fixed exchange rate can bring to forex trading.

Advantages of the Fixed Exchange Rate System

The policy delivers certain advantages for the government. It has proved to be an effective tool when it comes to stabilizing the currency inside the country. As a result, businesses of all sizes will find it simpler to scale, plan, and grow.

Another advantage is the ability of the country to borrow money. Investors know precisely how much they can get in foreign currency. Last but not least, the population feels a bit more confident about their currency, which helps to attract more investors, promote the economy, and develop trade.

Additionally, a fixed exchange rate system comes with the following advantages:

1. Reduced Currency Fluctuation. It does not matter if you are a long-term or short-term investor involved in Forex trading, a fixed exchange rate is a great tool to avoid currency fluctuation. The rate is always the same no matter what happens to the market, which means clarity and simplicity in making predictions. It does not matter how the market performs. You have an opportunity to maintain your purchasing power despite unexpected changes. Another key factor is that a fixed exchange rate system does not leave any space for arbitrage (taking advantage of different prices on two different markets), which is an important safety option.
2. Encouraged Investments. With a fixed exchange rate system, the country becomes more stable compared to the economy with a floating rate. This fact attracts more potential investors. The fact that the inner currency is tied to the currency of another country creates stability for businesses. At the same time, investors are always aware of how much their currency will be worth over a specific term.
3. Lowered Inflation. While the inner currency is pegged to the currency of another country, it prevents inflation from growing. Besides, the movement has a chance to keep control over product and service prices making them affordable for the population despite the income. As a result, we have a stronger and improving economy.

Disadvantages of the Fixed Exchange rate System

Despite all benefits, a fixed exchange rate is a sign of something going wrong in the country’s economy. One of the main advantages is the possibility of artificially high inflation occurring from time to time. What’s more, some countries will find it hard to adjust their currency value to the currency rate of another country, especially in reference to goods and service prices.

It can lead to a more expensive import/export. In other words, a country may sell its goods at a lower price than expected. Other fixed exchange rate disadvantages include the following:

1. Reduced flexibility. A fixed rate limits the flexibility a country may need when taking specific economic actions. For instance, a weak economy will have nothing to do but devalue its currency in an effort to boost exports. As a result, we have growing inflation and reduced economic development. The situation may even be worth leading to a trade deficit and a set of other financial problems.
2. Increased interest rates. To keep the currency under control and ensure its stability, a country will need to increase interest rates. As a result, businesses will find it harder to borrow money, especially in a foreign currency, while its flows can be limited by central banks. The population will face a rapid price increase and the inability to buy expensive foreign products.
3. A Lack of currency value control. A fixed rate makes it harder to maintain control over the currency value as well as keep it stable. There is a high possibility of the inner currency value decline if there is a large money deficit. As a result, imports will grow in price while exports will become cheaper causing more serious economic problems.

Let’s have a brief look at the table with all the crucial pros and cons a fixed exchange rate system has:

The Bottom Line

A fixed exchange rate system is a tool to keep the currency value and economy stable. It helps to eliminate volatility and reduce fluctuation. These measures can be beneficial for businesses looking for a chance to recover after a recession. Besides, a fixed rate results in more predictable transactions, which is extremely important at a time of economic and market uncertainty.

On the other hand, it reserves less flexibility for the economy to make certain moves and adapt the currency value. What’s more, it can lead to a currency deficit, expensive imports, and cheap exports making it harder for the country to maintain international trade.

This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.