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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.
Managed float is when the controlling financial body will manipulate the exchange rate at will, choosing to let it free float, fixed to a rate, or kept within a desirable range.
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.
Revaluation - an increase in the value of the domestic currency with respect to a foreign currency in a managed float system.
Devaluation - a decrease in the value of the domestic currency with respect to a foreign currency in a managed float system.
Free float vs. managed float
What is the difference between free float vs. managed float? They share some similarities, especially since a managed float can choose to free float. Let's start by establishing what a free float is as well as its advantages.
A free float is when an exchange is not manipulated in any way; it is only changed by market forces. For simplicity, we'll refer to the dollar. The value of the dollar on the foreign exchange market will only change if the supply or demand for the dollar shifts. Let's consider an example, as illustrated in Figure 1 below.
Fig. 1 - Free float example
Suppose that a new American product has countries all over the world buying it. The global pandemic hits, and the demand for this product falls drastically. This leads to a fall in demand for the dollar, as fewer dollars are required to purchase the American good. In Figure 1 above, this is shown by the demand curve for dollars shifting leftwards from D1 to D2. With a floating exchange rate, this will depreciate the value of the dollar as its demand falls.
Alternatively, shifts in supply can change the value of the currency. Suppose that the Federal Reserve increases the money supply. Now dollars are not as scarce on the market, so they will drop in price or value. This is shown by the supply curve for dollars shifting from S1 to S2. This leads to a depreciation of the dollar.
The managed float is a free float with some state control. To clarify the difference between managed and free float, we'll list the tools that are used to manipulate a managed float.
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.
Switzerland is an example of managed float. The 2011 monetary policy lowered interest rates. The 2011 price ceiling in Swiss francs was at 0.83 euro cents.
Managed float system is used in Japan, Mexico, Thailand, Turkey, Sweden, Israel, Brazil, and India.
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.
Managed Float - Key takeaways
- Managed float is when the controlling financial body will manipulate the exchange rate at will, choosing to let it free float, fixed to a rate, or kept within a desirable range.
- Revaluation is an increase in the value of the domestic currency with respect to a foreign currency in a managed float system.
- Devaluation is a decrease in the value of the domestic currency with respect to a foreign currency in a managed float system.
- Managed float is essentially the same as the free float but where the currency value is allowed to fluctuate within certain limits.
- Managed float is maintained through tools such as monetary policy.
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Frequently Asked Questions about Managed Float
What is a managed float?
Managed float is when the controlling financial body will manipulate the exchange rate at will, choosing to let it free float, fixed to a rate, or kept within a desirable range.
Why do countries go for managed exchange rate system?
There are various reasons why countries go for managed exchange rate system, which allow them to:
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
What is the difference between a floating and managed exchange rate?
A free float is when an exchange is not manipulated in any way; it is only changed by market forces. The managed float is a free float with some state control.
Which countries use managed float?
Managed float system is used in Japan, Mexico, Thailand, Turkey, Sweden, Israel, Brazil, and India.
How is managed float exchange rate determined?
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.
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