IB Economics SLTopic 4 — The Global EconomyPaper 1 & 2Diagram skill~9 min read
Fixed and Managed Exchange Rates
Under a float, the market decides and the central bank watches. Under a peg, the central bank decides and has to defend that decision with real money. Most countries in practice sit somewhere between the two, letting the currency move but not too far.
📘 What you need to know
Under a fixed system the central bank pegs the currency to another one and intervenes to hold it there.
To support its currency it buys its own currency using foreign reserves, raising demand.
To weaken its currency it sells its own currency, raising supply.
A peg can be at parity (one for one) or at any agreed rate. Hong Kong has held its dollar close to a fixed rate against the US dollar for decades.
A deliberate move of the peg upwards is a revaluation; a deliberate move downwards is a devaluation.
Under a managed system the rate floats within a band, and the central bank steps in only near the edges.
Bands are usually not published, because speculators who knew them could bet against the central bank.
Defending a peg costs foreign reserves and ties up monetary policy, which is the real price of the certainty it buys.
Defending a peg
Suppose the currency is pegged at $1.25 and importers start buying more from abroad. To pay for those imports they sell their own currency, so supply shifts right and the market rate slips to $1.20. The peg is broken unless somebody buys that extra currency, and that somebody is the central bank, spending its reserves of foreign currency to do it.
To weaken the currency instead, the central bank does the reverse: it sells its own currency and buys foreign ones, which shifts supply right. That direction is unlimited, because it can always create more of its own money.
There is an asymmetry worth remembering. A central bank can hold a currency down forever, because it can print as much of its own money as it likes. Holding one up is different: that runs on foreign reserves, and reserves are finite. This is why speculative attacks always come at currencies that look too strong for their economy.
WORKED EXAMPLE
A central bank spends $40bn of reserves in a month defending its peg. Its reserves were $180bn. Calculate the share used and comment. [3]
Step 1: the share of reserves used(40 ÷ 180) × 100 = 22.2%Step 2: what that implies
At this rate the reserves last a little over four months.
180 ÷ 40 = 4.5 monthsStep 3: the comment the marks are for
A peg is only credible while markets believe the reserves can outlast the pressure. Once they doubt it, selling increases and the defence gets more expensive.
22.2% of reserves in one monthSpeculators watch this number. Falling reserves are the signal that a devaluation may be coming.
Revaluation and devaluation
Under a peg, the rate does not drift; it is moved. If the central bank decides the currency is too strong for its exporters, it announces a lower peg. That is a devaluation, and unlike a depreciation it happens on a particular day, by a decided amount.
WORKED EXAMPLE
A country devalues its currency by 20%, from $1.25 to a new peg. A good priced at 1,000 units of local currency is exported. Calculate the change in its dollar price. [3]
Step 1: the new peg1.25 × 0.8 = $1.00 per unitStep 2: the export price before1,000 × 1.25 = $1,250Step 3: the export price after1,000 × 1.00 = $1,000The foreign price falls from $1,250 to $1,000The domestic price never moved. Devaluation makes exports cheaper abroad without any firm cutting its own price.
The managed system
Almost every currency today is managed to some degree. The rate floats, but the central bank has a range it is comfortable with, and it intervenes when the rate drifts to the edge of that range. It gets some of the flexibility of a float and some of the stability of a peg.
Inside the band the rate behaves like a floating currency. At the edges it behaves like a peg. That is the whole design.
Comparing the three systems
Feature
Floating
Fixed
Managed
Who sets the rate
The market
The central bank
The market, inside limits
Certainty for traders
Low
High
Moderate
Reserves needed
None
Large
Some
Monetary policy
Free for domestic goals
Tied to defending the peg
Partly tied
Adjusts to a trade imbalance
Automatically
Not without a decision
Partly
Risk of speculative attack
Low
High
Moderate
The trade-off in one line: a fixed rate buys certainty and pays for it with reserves and monetary independence; a floating rate keeps both of those and pays for it with volatility.
💡 Exam tip
Say which curve the central bank shifts. Buying its own currency shifts demand right; selling it shifts supply right.
Use the right verbs. Appreciate and depreciate for floating; revalue and devalue for a peg.
Bring in the reserves constraint. It is the reason pegs fail, and it earns evaluation marks every time.
Mention monetary policy. A country defending a peg cannot set interest rates for its own economy.
Note the asymmetry: holding a currency down is easy, holding it up is limited by reserves.
Number your diagram points 1, 2 and 3 and refer to them in the writing, exactly as the analysis runs.
⚠️ Common mix-up
Saying the central bank buys foreign currency to support its own. It is the other way round: it buys its own with foreign reserves.
Using devaluation for a market movement. Devaluation is a policy decision under a peg.
Thinking a fixed rate cannot change. It changes when the central bank moves the peg.
Forgetting the cost of a peg. Certainty is bought with reserves and with monetary independence.
Treating managed and fixed as the same. A managed rate moves freely until it reaches the edge of the band.
Shifting the wrong curve for intervention and ending up arguing that the bank weakened a currency it was trying to defend.
Up next: What the Balance of Payments Records — the accounts that track every one of these currency flows, and why they are the other half of this story.
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