Managed flexibility in exchange rate22nd January 2021
Managed floating rate system refers to a system in which foreign exchange rate is determined by market force and central bank is a key participant to stabilize the currency in case of extreme, appreciation or depreciation.
Under Managed floating rate system, also called dirty floating, central banks to buy and sell foreign currencies in an attempt to moderate exchange rate movement whenever they feel that such actions are appropriate.
Against the two extremes of rigidly fixed and freely flexible exchange rates, a system of controlled or managed flexibility is suggested on practical considerations into the exchange rate regime.
The focus on intermediate regime between fixed and floating exchange rate is desirable for a prudency to eliminate the drawbacks and capture the advantages of both extreme systems.
Under the managed or controlled flexibility of exchange rate system, the scope of the range of flexibility around fixed par values is determined by the country as per its economic need and the prevailing trend in the international monetary system.
Managed floating exchange rate system is essentially based on the par value concept under the IMF guidelines.
Managing or controlling exchange rates requires the country to intervene in the foreign exchange market time to time in view of the emerging BOP disequilibrium.
- Adjustable Peg System:
Under the Bretton Woods System, the exchange rates of different currencies were pegged in terms of gold or the U.S. dollar at the rate of $ 35 per ounce of gold. The nations were allowed to change the par values of their currencies when faced with a ‘fundamental’ disequilibrium.
- Crawling Peg System:
The crawling peg system was popularised in mid-sixties by such prominent economists as William Fellner, J.H. Williamson, J. Black, J.E. Meade and C.J. Murphy. This system is a compromise between the extremes of freely fluctuating exchange rates and perfectly stable exchange rates. It was devised in order to avoid the disadvantage of relatively large changes in par values and possibly destabilising speculation associated with the system of adjustable peg.
In case of the Bretton Woods adjustable peg, sudden and large changes in exchange rates have to be made. These are clearly undesirable and should be avoided.
- Policy of Managed Floating:
The exchange rates may continue to fluctuate, even if speculation is stabilising, on account of the variations that take place in the real sectors of the economy. The fluctuations in exchange rate tend to have an adverse effect upon the flow of international trade and investments. The Smithsonian Agreement made on December 18, 1971 provided for the widening of margin of fluctuations from 1 percent on each side of the exchange parity to 2.25 percent on each side of the par value of exchange.
Clean and Dirty Float Systems:
In connection with a system of managed float, it may be pointed out that a distinction is sometimes made between a clean float and dirty float.
(i) Clean Float:
In case of clean float, the rate of exchange is allowed to be determined by the free market forces of demand and supply of foreign exchange. The exchange rate is permitted to move up and down. The foreign exchange market itself corrects the excess demand or excess supply conditions without the intervention of monetary authority. Thus, the policy of clean float is identical to the policy of freely fluctuating exchange rates.
(ii) Dirty Float:
In case of a dirty float, the exchange rate is sought to be determined by the market forces of demand and supply for foreign exchange. However, the monetary authority intervenes in the foreign exchange market through the pegging operations either to smoothen or to eliminate the fluctuations altogether. It means even the long term trend in exchange rate is manipulated by the monetary authority. Such a policy of managed float is understood as the policy of ‘dirty float’.
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