How Does Managed Floating Exchange Rate Work?

Since the Great Recession of 2007-2009, many countries have been trying to find ways to stimulate their economy. Most of these countries use one strategy: managed floating exchange rate regimes. 

You’ve probably heard about managed floating exchange rates but don’t know what they are or how they work. This post will cover what managed floating exchange rates are, why they exist, how they work, and if this type of currency regime is successful or not.

What is Floating Exchange Rate?

A managed floating exchange rate is a currency regime used to manage its foreign exchange rates. This means the central bank (which manages this process) can control how much value its money has concerning other currencies and assets like gold or commodities such as oil.

There’s a difference between managed floating exchange rates and floating exchange rate regimes. 

So, what is floating exchange rate?

A floating exchange rate regime refers to an economy in which its currency will eventually be used for all forms of trade. Therefore, the currency will have a floating exchange rate, which means it can be traded freely on the open market, and its value is determined by supply and demand forces only.

This is different from a managed floating exchange rate, where countries put restrictions on the movement of their currency. They do this to avoid economic problems such as inflation or deflation, which can significantly impact trade and growth within their country.

How a Managed Floating Exchange Rate Works

A managed floating exchange rate is a “dirty float” because exchange rates in this regime are allowed to fluctuate freely. However, in the event of instability, central banks will intervene to bring the rate back to equilibrium. 

The central bank manages this through open market operations or buying and selling currencies from other countries on the foreign exchange market.

There are usually some limitations and interventions involved in a managed floating regime. These interventions and limitations help the countries control inflation rates without hindering international trade. 

The central bank will set a specified band within which the demand for the dollar shouldn’t supersede. If demand goes beyond this band and the dollar’s value increases against the country’s currency, the central bank balances things. 

The central bank will sell the country’s currency to balance it within the band and achieve a state of normalcy.

In general, managed floating regimes have greater capital mobility and give citizens more freedom when investing or saving their money.

The Benefits of Using a Managed Floating Exchange Rate Regime

Countries using managed floating exchange rate regimes enjoy several benefits. Some of these benefits include:

Better Management of the Economy

With managed floating, the central bank can better manage an economy even in an economic crisis. This system helps increase the government’s credibility among global investors, thus creating a more stable economy. 

Greater Control over Inflation and Interest Rates

Managed floating exchange rate regimes give central banks better control over inflation and interest rates. It becomes easier for them to adjust monetary policy according to the economy’s needs. 

Higher International Competitiveness

Countries using managed floating currencies enjoy higher international competitiveness due to low currency volatility, making importing raw materials and exporting finished products cheaper. 

Decreased Inflow of Foreign Capital

Managed floating exchange rates help control capital inflow and outflows, which is beneficial for economies with a chronic deficit in the current account balance. Such managed currency regimes are often seen as safe havens during economic crises, and investors flock to invest their money in these currency regimes until things improve again.

Self-Correcting Nature of Managed Floating Exchange Rate System

The managed floating currency regime is self-correcting, as the central bank has control over buying or selling its currency. This helps keep inflation at bay by targeting a specific growth rate for the money supply in relation to the GDP. 

The flexibility means that no exchange rates are fixed unless the government chooses to do so. In times of economic crisis, managed floating exchange rates can become fixed when the government intervenes in foreign markets and imposes capital controls on its citizens.

Low Cash Reserves Requirements

The managed floating exchange rate system allows the central bank to keep lower cash reserves, as it can create money when in need of some. This means that managed floating regimes can stimulate economic activity by injecting liquidity into the market when needed.

The Central Bank Doesn’t Have to Intervene Frequently

While central banks have to constantly intervene and manipulate the financial operations in a fixed regime, they don’t have to do the same in a floating regime.

Here, there’s no parity to uphold, and as a result, there’s no need to protect the gold parity, as is the case with the fixed cost regime.

There’s a More Solid Protection from other Countries’ Economic Problems

When working under the fixed exchange rate regime, it becomes inevitable for countries to export their macroeconomic problems to other countries. If an importing country is experiencing inflation, it can quickly spread this problem to the exporting country when trading under a fixed regime. 

The exporting country will have to increase the prices of its commodities to counter the rising demand from the importing country.

However, this is not always the case with a floating exchange rate regime where countries are more protected against other countries’ macroeconomic problems. 

Here, the inflation problems from the importing country only lower their currency value and reduce their purchasing power, thus lowering the demand for goods from the exporting country. The exporting country doesn’t have to increase commodity prices to match rising demand.

The Disadvantages of Using a Managed Floating Exchange Rate Regime

Using this kind of regime has its shortcomings, which include:

An Element of Uncertainty

The central bank is not committed to any fixed exchange rate in managed floating exchange rates, and this means that it can decide when and how much money will be injected into the economy.

This causes a lot of uncertainty in markets, resulting in greater volatility when compared with other regimes like pegged or adjustable pegs (fixed).

Need to Manage Currency Risk

Managing managed floating exchange rates is about managing fiscal policy and monetary policy. This means that you’ll have to manage currency risk because no country wants its currency value to fluctuate too much. Otherwise, it will lose out on international trade, and foreign investments could be withdrawn from the economy if investors predict an impending fall in currency value.

Increased Speculation

Managing managed floating exchange rates will lead to increased speculation as there are no restrictions on the money supply. Market forces determine how much currency is supplied, and demand determines what price should be charged for it. 

Managed Floating Rate System is Not Perfect for All Countries

The good news is that you can now answer the question, “What is the floating exchange rate?”

However, the managed floating rate system is not ideal for all countries. Countries with high inflation rates are better off under a fixed exchange rate regime, where they have more control over their economy.

Other factors should be considered when determining what kind of managed float to implement; however, you now know the basics behind managed floating exchange rates.