Managed Floating Exchange Rates

In this revision video we focus on the economics of managed floating exchange rates.

A managed floating exchange rate is an exchange rate system that allows a nation’s central bank to intervene regularly in foreign exchange markets to change the direction of the currency’s float and/or reduce the amount of currency volatility. This exchange rate system is also known as a “dirty float”.

Motivations for managing a floating currency through intervention

Central bank might attempt to bring about a depreciation to:

• Improve the balance of trade or improve the current account by making exports more price competitive
• Reduce the risk of a deflationary recession - a lower currency increases export demand and increases the domestic price level by making imports more expensive
• Rebalance the economy away from consumption towards higher exports and capital investment

Or to bring about an appreciation of the currency

• To curb demand-pull inflationary pressures
• To reduce the prices of imported capital and technology or essential inputs to enhance long run growth potential

Limits to central bank intervention to manage a currency’s value

1. Requires large-scale foreign exchange reserves – many smaller and relatively poorer countries do not have these
2. Central banks intervening on their own may have little or no market power against the sheer weight of speculative buying and selling in global currency markets (turnover > $6 trillion a day)
3. Changing interest rates to influence a currency might conflict against other macroeconomic objectives - raising interest rates to support a currency might stifle growth