by the UK authorities in the case of downward pressure on the value of the pound.
Again, this analysis can be applied to other currencies.
The exchange rate is fixed at £1 = $2, and the government wants to maintain that rate.
If a balance of payments deficit develops, brought about by an increase in imports,
exports remaining the same, there will be an excess supply of pounds at the fixed
exchange rate. In a free market the value of the pound would fall until the excess supply
had disappeared. However, this is not a free market, and the government must buy up
the excess supply of pounds in order to maintain the exchange rate at £1 = $2. Thus the
demand curve moves to the right and the exchange rate has been maintained at the same
level. Alternatively if there is excess demand for pounds, the government has to supply
pounds to the market in order to maintain the fixed exchange rate.
A prime advantage of a fixed exchange rate is that there is less uncertainty in the
market, everyone knows what the exchange rate will be in a year’s time, and long-term
planning is made easier. It also reduces the likelihood of speculation in the foreign
exchange markets. One major disadvantage, however, is that there is no longer an automatic
mechanism for rectifying any balance of payments problems as there is in the
case of the floating exchange rate and this means that government intervention is necessary,
not just to support the exchange rate, but also to overcome any balance of
payments problems. Added to this, a fixed exchange rate is not sustainable in the case of
persistent deficits or surpluses. In the event of a surplus, the government must supply
pounds to the market and if the surplus persists, then eventually the government will
exhaust its reserves and might well have to revalue the pound, i.e. increase the exchange
rate of the pound. In the case of a persistent deficit, the size of the government’s
reserves will be increasing over time and the government may have to devalue the
pound to correct the problem.