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Study notes

Exchange Rates - Managed Floating Exchange Rates

  • Levels: A Level, IB
  • Exam boards: AQA, Edexcel, OCR, IB, Eduqas, WJEC

A managed-floating currency when the central bank may choose to intervene in the foreign exchange markets to affect the value of a currency to meet specific macroeconomic objectives.

For example the central bank might attempt to bring about a depreciation to

  • (i) Improve the balance of trade in goods and services / improve the current account position
  • (ii) Reduce the risk of a deflationary recession - a lower currency increases export demand and increases the domestic price level by making imports more expensive
  • (iii) To rebalance the economy away from domestic consumption towards exports and investment
  • (iv) Selling foreign currencies to overseas investors as a way of reducing the size of government debt

Or to bring about an appreciation of the currency

  • (i) To curb demand-pull inflationary pressures
  • (ii) To reduce the price of imported capital and technology

Overall, one key aim of managed floating currencies is to reduce the volatility of exchange rates. This is because big fluctuations in the external value of a currency can increase investor risk and perhaps damage business confidence. If the risk for example of overseas investor buying a government’s bonds rises, then they may demand a higher interest rate (or yield) on those bonds as compensation.

Managed floating exchange rates might also be used as a tool for a government to restore or improve the price competitiveness of exporters in global markets or perhaps respond to an external economic shock affecting their economy.

Latest IMF classification of countries using a managed floating system:

Albania, Argentina, Armenia, Brazil, Colombia, Georgia, Ghana, Guatemala, Hungary, Iceland, India, Indonesia, Israel, Kazakhstan, Korea, Moldova, New Zealand, Paraguay, Peru, Philippines, Romania, South Africa, Thailand, Turkey, Uganda, Ukraine, Uruguay

IMF classification of countries using a free-floating currency:

Australia, Canada, Chile, Japan, Mexico, Norway, Poland, Russia, Sweden, United Kingdom, United States, European Union (Euro)

Exam hint:

To manage a floating currency, the central bank needs to have sufficient reserves of foreign currency available should it need to intervene. There are also risks involved in changing domestic interest rates to have an impact in currency markets. For example, higher interest rates designed to attract hot money inflows and cause a currency appreciation might also have the effect of reducing consumer demand and cutting planned business investment.

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