In spite of the advantage of promoting relatively low inflation, a fixed exchangerate
system makes countries vulnerable to speculative attacks on their currencies.
Recall that preservation of fixed exchange rates requires the government to purchase
or sell domestic currency for foreign currency at the target rate of exchange. This
requirement forces the central bank to maintain a sufficient quantity of international
reserves in order to fulfill the demand by the public to sell domestic currency for
foreign currency at the fixed exchange rate. If the public thinks that the central
bank’s supply of international reserves has decreased to the level where the ability
to fulfill the demand to sell domestic currency for foreign currency at a fixed
exchange rate is doubted, then a devaluation of the domestic currency is anticipated.
This anticipation can result in a speculative attack on the central bank’s remaining
holdings of international reserves. The attack consists of huge sales of domestic currency
for foreign currency so that the decrease in international reserves is expedited,
and devaluation results from the decline in reserves. It is no wonder that the most
important recent currency crises have happened to countries having fixed exchange
rates but demonstrating a lack of political will to correct previous economic
problems.