Several different types of fixed exchange rates exist. There are gold standards, reserve currencies, crawling pegs, and interest rate parity. The type of exchange rate you choose depends on the kind of trade you are doing.
Interest rate parity
Keeping interest rate parity between different types of fixed exchange rates is not a foregone conclusion. It is often a gamble, requiring both the government and the central bank to act on changes in expectations. Some governments do not even allow the market to decide the value of their currency. In some cases, the government has to make spending cuts and increase tax rates in order to make up for the losses in inflation revenues.
A key component of keeping interest rate parity is the ability to prevent capital outflows. This is achieved by keeping a domestic interest rate that is higher than the world interest rate. This prevents capital from leaving the country to re-enter the economy at higher rates.
Another key component is the ability to prevent currency depreciation. This can be done through sterilized central bank intervention. The central bank sells foreign currency in order to prop up the local currency. Eventually, the reserves run dry.
Crawling peg
Using a crawling peg fixed exchange rate has some advantages, but it also has its disadvantages. In particular, the system is susceptible to speculators and its mechanisms are susceptible to misuse.
The system may be accompanied by a high degree of opacity, which is not conducive to economic growth. On the other hand, it may provide stability aplenty for trading partners. The system is also capable of adjusting the par value as market conditions warrant. This allows the central bank to buy and sell its currency in a coordinated fashion. The best part is, this system does not require a hefty capital outlay.
While the crawling peg fixed exchange rate may be the rage, it has its drawbacks, and a more nimble system may be the only way to go. It is not surprising that the country has opted to switch over, in part, to a more manageable floating peg. This has also allowed the RBZ to intervene, as well as provide more of a focus on financial inclusion, which will ultimately benefit everyone.
Gold standard
During the 1870s and into the first decades of the 20th century, most European countries were in the process of adopting the gold standard, which limited the power of governments and banks to cause price inflation. It also created an international system of fixed exchange rates.
The classical gold standard prevailed from 1880 until 1914 when it was overtaken by World War I. This monetary system provided stability and security in international trade. It also allowed the sterilization of foreign gold inflows and foreign prices.
The gold standard system was driven by market forces. The demand for gold was determined by the commodity market and the money market. It also imposed a limit on the domestic money supply and a cap on the quantity of gold to be held by the country.
It was a self-equilibrating system, which meant that price levels would tend to go back to their prewar level. However, as the supply of gold diminished, the possibility of a confidence crisis grew.
Reserve currency
Depending on their respective macro economies, countries can adopt different types of fixed exchange rates. These fixed rates can help to establish a credible low-inflation policy. They also reduce the risk to businesses and investors. These policies can limit inflation in the economy while fostering full employment.
In the Bretton Woods system, which lasted from 1945 to 1971, foreign exchange rates were fixed by the central bank of a country. These exchange rates were established by an agreement between participating countries. This was an attempt to prevent currencies from adjusting against each other. However, the United States began printing more money in the early 1970s to fund the Vietnam War, and the agreement fell apart.
In the late 1960s, the International Monetary Fund (IMF) created SDRs (Special Drawing Rights) as an international reserve currency. At first, the SDR was defined as the equivalent of 0.888671 grams of fine gold. However, the IMF later redefined the SDR as a weighted average of four currencies.