Definition of Fixed Exchange Rate (Fed Funds Rate)

Fixed Exchange Rate

The one clear way to achieve a fixed exchange rate is to adopt a common currency in two countries. For example, within the U.S., the exchange rate between New York State and California is fixed at 1.00 because both use the same currency. The euro achieves the same end if the countries involved continue to use that currency.

For two countries with two currencies, maintaining a fixed exchange rate requires at least one of the two countries to pursue some policy to achieve that end. Simply posting an exchange rate and placing soldiers with rifles at the border to enforce it is possible, but not likely to lead to much economic activity. A market-based approach is for one of the countries to commit to a monetary policy that targets the exchange rate. The practical problem is that "fixed" may be true only up to the point where monetary policy is changed to address other targets such as domestic unemployment or inflation. The Mundell-Fleming Model shows how a government can maintain a fixed exchange rate.

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