Which of the following is characteristic of the fixed exchange rate system? Group of answer choices:
A) utilized by most advanced economies
B) rates based on supply and demand forces
C) value of currency is set relative to the value of another
D) allows for monetary policy flexibility
The correct answer and explanation is:
The correct answer is: C) value of currency is set relative to the value of another
In a fixed exchange rate system, the value of a country’s currency is tied or pegged to the value of another currency, often a major one like the U.S. dollar or gold. This arrangement means that the country’s central bank or government intervenes in the foreign exchange market to maintain the currency’s value within a narrow range, relative to the currency to which it is pegged.
Under this system, the government or central bank is responsible for ensuring that the exchange rate remains stable, even if the supply and demand for currency fluctuate. To do this, the central bank may buy or sell its own currency in the open market or adjust interest rates, depending on the circumstances. The fixed exchange rate system contrasts with a floating exchange rate system, where the value of a currency is determined by market forces, such as supply and demand, without direct government intervention.
A key characteristic of the fixed exchange rate system is the stability it provides for international trade and investment. Businesses and investors can engage in transactions with greater certainty because the exchange rate risk is reduced. However, this system also comes with drawbacks. A fixed exchange rate system can limit the country’s ability to adjust its monetary policy since the central bank must maintain the peg, often at the expense of controlling domestic inflation or responding to domestic economic conditions. In times of economic instability, defending a fixed exchange rate can be challenging, and the country may need to devalue or revalue its currency, which can lead to inflation or a loss of investor confidence.