6.12 Managed Float Exchange Rate System previousnext

A managed float exchange rate system is an international financial arrangement, whereby central banks intervene only periodically, not necessarily to support a country's currency, but rather to stabilize volatile fluctuations in foreign exchange rates. A managed float is some times called a "dirty float" because exchange rates are free to fluctuate, but central banks are committed to intervene under conditions of perceived instability. The central bank steps in to offset only so much of a change in demand or supply to bring the exchange rate back into an acceptable "band" or range of exchange rates. The last part explains the advantages and disadvantages of a managed float exchange rate system.

When demand increases from D0 to D1, the excess demand puts upward pressure on the value of the dollar and the value of the dollar increases from 2.0dm/$1 to 2.5dm/$. Since 2.5dm/$ is above the upper bound of the specified band, the central bank steps in and sells the country's currency to bring the exchange rate back down within the band.


When demand decreases from D0 to D2, the excess supply puts downward pressure on the value of the dollar and the value of the dollar decreases from 2.0dm/$ to 1.5dm/$. Since 1.5dm/$ is below the lower bound of the specified band, the central bank steps in and buys the country's currency to bring it back up within the band.

When supply increases from S0 to S1, the excess supply puts downward pressure on the value of the dollar and the value of the dollar decreases from 2.0dm/$ to 1.5dm/$. Since 1.5dm/$ is below the lower bound of the specified band, the central bank steps in and buys the country's currency to bring it back up within the band.

When supply decreases from S0 to S2, the excess demand puts upward pressure on the value of the dollar and the value of the dollar increases from 2.0dm/$ to 2.5dm/$. Since 2.5dm/$ is above the upper bound of the specified band, the central bank steps in and sells the country's currency to bring it back down within the band.

The smaller the band, the more stable the exchange rate. However, a small band requires more central bank intervention to keep the exchange rate within the band. The larger the band, the less stable the exchange rate. However, a large band requires less central bank intervention.

top Advantages

The managed float attempts to combine the advantages of both the fixed and flexible exchange rate systems, depending on the degree of instability. The less instability, the less intervention is necessary by central banks and they can pursue quasi-independent domestic monetary policies to stabilize their own economies. The greater the instability, the more intervention is necessary by central banks and the less free they are to pursue independent domestic monetary policies because they are frequently required to use their money supplies to calm disturbances in the foreign exchange markets.

top Disadvantages

The big problem with a managed float comes in determining the timing and magnitude of the instability and the necessary intervention. Does a one day drop (rise) in a currency warrant intervention? A week? A month? A year? Five years? Is a 1% drop (rise) in a currency's exchange rate destabilizing? A 2% change? A 5% change? A 10% change? If the central banks are too quick to respond or if the amount of intervention is inappropriate, their actions may be further destabilizing. This increased instability has a tendency to dampen international flows and contract world trade. If they wait too long, permanent damage may be done to some countries' trade and investment balances.


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