Currently, the two major currencies of the 21st century are the US dollar (USD) and the Euro (EUR). These currencies are recognized and used in international transactions as well as deferred payments worldwide. Since the gold and silver standards were abandoned by developed economies during the 20th century, major currencies such as the USD and the EUR are said to ‘float’ freely on the foreign exchange markets. This means that their price varies daily as it fluctuates according to the forces of supply and demand as well as their reputation. Certainly central banks throughout the world implement monetary policies in their respective countries; however, their control over the currency’s value is not absolute.
Currencies and the Global Foreign Exchange
Not all currencies have the stability or international standing needed to withstand the winds of the global foreign exchange market. In fact, a major or minor fluctuation in world markets could send small economies with floating national currencies into a recession, hyperinflation, or worse. Therefore, just as some countries fixed or ‘pegged’ their currencies against reserves of precious metals in the past, some current governments decide to fix the exchange of their national currencies against the EUR or the USD. In fact, the EUR itself was created as a common currency amongst neighboring nations and intensive trade partners who wanted a very fixed exchange rate (1:1).
Small economies, particularly countries who engage in substantial trade, are particularly vulnerable to currency risk and volatility. This means that their domestic economy and their citizens’ savings could be severely harmed by monetary fluctuations. For example, a severe devaluation of the national currency might lead to high inflation and an unsustainable cost of living. Similarly, an abrupt valuation of the currency could negatively affect the country’s exports, trade balance, and its GDP. Therefore, some governments, through their central banks, decide to peg or fix the domestic currency’s exchange against a major actor such as the USD or the EUR.
A fixed-exchange currency provides small countries and economies with steadiness in domestic markets, stable costs in terms of international trade, and controlled inflation. However, a fixed-exchange rate implies that the smaller economy gives up most of its monetary policy autonomy. In order for a fixed-exchange to work, the smaller economy has to follow the monetary policy of the central financial authorities of the major currency, in these cases the US Federal Reserve or the European Central Bank. Furthermore, the smaller economy needs to maintain substantial reserves of the major currency in order to conduct foreign exchange market operations. Only by constantly selling and buying its own domestic currency against the USD or the EUR, can a central bank defend and sustain its fixed exchange rate.
Some examples of fixed-exchange currencies are the West African and the Central African CFA Franc (XOF & XAF), official currencies in 14 nations. Although managed by separate central banks both CFA Francs are of equivalent value and fixed against the EUR at an exchange of 656 to 1€. Similarly, currencies such as the Bahamian Dollar and the Cuban Convertible Peso have a fixed-exchange of one-to-one with the USD.