Managed Float

Imagine you are holding a dollar; If you had the power to control how much that dollar is worth, what would you do? Would you only change the value if it started to fall? Would you raise the value of the dollar so you can buy more things? Would that cause inflation that would negate the growth in value? Believe it or not but countries have some control or pre-planned lack of control over the exchange rate of their currency. This explanation will fill you in on all the details you need to know about the exchange rates in managed float, so keep reading on!

Managed float definition

Before we can cover the definition of managed float, we need some background information to make it clear. The global financial market has hundreds of currencies with varying values and exchange rates circulating the globe, fluctuating in price. An exchange rate will affect a country's ability to purchase imports, as well as determine the attractiveness of their exports.

Some countries, like the United States, operate on what is called a free float, where the exchange rate value of the dollar is determined by supply and demand in the global market. Other countries will peg their currency either to another country's currency or at a fixed rate.

What happens when a country determines they don't want a free-floating market exchange rate but also don't want a fixed one either? These countries then practice a mix of both, which is referred to as a managed float, also called a dirty float.

A managed float can be anything the controller wants it to be. If they think the market is stable, they can allow it to free float, allowing efficient allocations. It can also be when the controlling body intervenes to control market fluctuations in the exchange rate or set it to a target level.

To better understand exchange rates, it'll be helpful to cover some relevant terms.

When a country's floating exchange rate is increasing, it's generally referred to as appreciation. When a managed exchange rate appreciates, it is referred to as revaluation.

On the other hand, when a country's floating exchange rate is decreasing, it's called depreciation. When a managed exchange rate depreciates, it is referred to as devaluation.

There are a few ways that controlling bodies manage the exchange rate. One way of controlling the exchange rate is monetary policy, such as decreasing the interest rate. Monetary policy refers to the manipulation of the money supply through interest rate channels. The following are examples of actions used to maintain a managed float.

• 1. Decrease in interest rate

  2. Buying foreign currency

  3. Foreign exchange control

Managed float exchange rate

Why would a country have a managed float exchange rate? Well, there are several advantages to having a managed float and a few drawbacks. Let's consider how the exchange rate affects trade within the domestic country and its imports and exports.

Exports are affected by the exchange rate because it alters the price consumers have to pay.

Part of managing an exchange rate is keeping it partially fixed within the desired range. Let's see some examples of this.

Managed exchange rate diagram

A managed exchange rate is most easily understood by viewing it on a diagram. Figure 2 below is a supply and demand graph for a given currency. The X-axis is the quantity of the currency available, and the Y-axis is the exchange rate. The supply curve (S) represents the available supply of money to be traded. The demand curve (D) is the market demand for the currency.

Because this graph represents a managed exchange rate, we know that the equilibrium exchange rate (ER*) is being monitored and controlled. The equilibrium quantity (Q*) is the quantity of money that maintains the desired exchange rate. This is because changes in the quantity of currency will cause the exchange rate to fluctuate, so the quantity of currency must be monitored to maintain it.

Fig. 2 - Managed float example

Figure 2 above provides a visual representation of how to manage a currency. Upper and lower limits are set to allow the currency to float to some degree. If the exchange rate approaches or goes past the limit, then the governing body will take steps to control it. This is usually done through tools such as monetary policy.

Pros and cons of managed floating exchange rate

What are the pros and cons of a managed floating exchange rate? Let's go over them below!

• Pros of managed floating exchange rate:
• 1. Improve the balance of trade
• 2. Reduce the risk of deflationary recession
• 3. Re-balance the economy
• 4. Curb demand-pull inflationary pressures
• 5. Reduce prices of import
• 6. Provides stability for investors and consumers

• Cons of managed floating exchange rate:
• 1. Can lead to cost-push inflation
• 2. Less flexibility for the use of interest rates by the government
• 3. Repercussions of setting a 'wrong' rate
• 4. Difficult to manage
• 5. Can send an economy into a recession
• 6. Investors leave if exchange rate is undesirable for them.