Floating Exchange Rate Regime

A floating exchange rate regime is one in which a country s currency is allowed to fluctuate with changes in the demand and supply of the currency. Therefore, the value of the currency is determined by the market, i.e. by the interactions of thousands of banks, firms and other institutions seeking to buy and sell currency for purposes of transactions for clearing, hedging, arbitrage and speculation. Therefore, when the demand of a currency increases then its value appreciates whereas, when the demand of a currency falls, its value depreciates. Conversely, when the supply of a currency is more, then the currency depreciates in value whereas when the supply of the currency decreases, then currency appreciates. Also, in a floating exchange rate regime, the government does not make any attempt to peg the country s currency against any base currency. This leads to large fluctuations and volatility in the market. As the Bretton Woods system (pegging the US dollar to gold and the other currencies to US dollar) fell apart in 1971 due to the problems with the US balance of payments, Richard Nixon, the then President of the US, abandoned this system of pegging the dollar against gold. This came to be known as the Nixon Shock and brought about major changes in the world economy. Switching away from the fixed exchange rate system after 27 years was a very difficult step for the US, and was more of a necessity than a voluntary action. Finally, the floating exchange rate system, which is in place today, was formalized at the Jamaican Agreement in 1976. In the years since 1971 when the United States finally abandoned the fixed exchange rate system and convertibility of the dollar into gold, most world currencies have traded at floating, or flexible, exchange rates. In the modern world, the majority of the world's currencies are floating. Central banks often participate in the markets to attempt to influence exchange rates. Such currencies include the most widely traded currencies: the United States dollar, the euro, the Norwegian Krone, the Japanese yen, the British pound, the Swiss franc and the Australian dollar. The Canadian dollar most closely resembles the ideal floating currency as the Canadian central bank has not interfered with its price since it officially stopped doing so in 1998. The US dollar runs a close second with very little changes in its foreign reserves. On the contrary, Japan and the UK intervene to a greater extent. Traditionally, the floating currency rates are preferred to fixed currency exchange rates, a view taken by most liberal economists. They insist that the floating rate reflects the fundamental factors like trade balances, inflation, unemployment, foreign investment, etc., which form the base for supply and demand of a particular currency, and therefore, form a real and correct market price. In today s world, it is taken for granted that a developed economic market must use a floating system of currency exchange rates, which also diversifies the risks of a sudden currency exchange shock. The floating currency rates are the base for the Forex market trading as well.

Fear of Floating Worldwide, a majority of the developing nations follow the Managed float system of exchange rate, followed by fixed exchange rate regime. However, it has been observed that a number of these emerging economies suffer from a so-called Fear of Floating . This implies that even though

economists world over consider floating exchange rate as a superior regime, it is not one favored by emerging economies. There are several reasons for this fear. Primarily, the emerging economies are concerned about the large fluctuations in the value of their currency, which is characteristic of this system. This leads to inflation and these nations need to have appropriate sytems in place to rein inflation in. Another matter of concern would be the speculations against the currency which have great potential in altering the market scenario and the value of the currency. For this reason, a country needs to have sufficient foreign exchange reserves to back up its currency in case of sudden, large fluctuations in the foreign exchange market.

Arguments in Favour of a Floating Exchange Rate

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Automatic balance of payments adjustment - Any disequilibrium in the balance of payments will tend to be resolved by a change in the exchange rate. For example, if India has a balance of payments deficit then the rupee will depreciate in value. This is because imports will exceed exports, as a result of which the supply of rupee on the foreign exchanges will be increasing as importers sell rupees (and buy dollars) to pay for the imports, which will drive its value down. The effect of the depreciation should be to make your exports cheaper and imports more expensive, thereby increasing the demand for your goods abroad and reducing demand for foreign goods in your own country, therefore dealing with the balance of payments problem. Conversely, a balance of payments surplus should be eliminated by an appreciation of the currency. When the exports exceed imports, the supply of dollars on the foreign exchange increases whereas the demand for rupee increases due to the exporters demanding these dollars to be converted into rupees. As a result of this, the value of rupee will go up as against the dollar, making exports more expensive as imports become cheaper. Therefore. The balance of payments problem is solved. Freeing internal policy - With a floating exchange rate, balance of payments disequilibrium should be rectified by a change in the external price of the currency. However, with a fixed rate, curing a deficit could involve a general deflationary policy resulting in unpleasant consequences for the entire economy, such as unemployment. The floating rate allows governments the freedom to pursue their own internal policy objectives such as growth and full employment without external constraints. Absence of crises - Fixed rates are often characterized by crises as pressure mounts on a currency to devalue or revalue, that is, realign with the current market conditions. The fact that with a floating rate, such changes are automatic should remove the element of crisis from international relations. Flexibility - Post-1973 there were great changes in the pattern of world trade as well as a major change in world economics as a result of the OPEC oil shock. A fixed exchange rate would have caused major problems at this time as some countries would be uncompetitive given their inflation rate. The floating rate allows a country to re-adjust more flexibly to external shocks. Lower foreign exchange reserves - A country with a fixed exchange rate regime usually has to hold large amounts of foreign currency in order to maintain their currencies at a fixed rate as they have to buy and sell these reserves on the foreign exchange in order to maintain their currency at the fixed rate. These reserves however have an opportunity cost as they could be invested elsewhere and obtain higher returns. This is the problem currently being faced by China, which has a fixed rate regime, and has pegged the Yuan against the US Dollar.

Disadvantages of the Floating Rate

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Volatility - The fact that a currency changes in value from day to day introduces instability or uncertainty into trade. Sellers may be unsure of how much money they will receive when they sell abroad or what their price actually is abroad. Of course the rate changing will affect price and thus sales. In a similar way importers never know how much it is going to cost them to import a given amount of foreign goods. This uncertainty can be reduced by hedging the foreign exchange risk on the forward market. Lack of investment - The uncertainty can lead to a lack of investment internally as well as from abroad. Speculation - Speculation will tend to be an inherent part of a floating system and it can be damaging and destabilizing for the economy, as the speculative flows may often differ from the underlying pattern of trade flows. Lack of discipline in economic management - As inflation is not punished there is a danger that governments will follow inflationary economic policies that then lead to a level of inflation that can cause problems for the economy. The presence of an inflation target should help overcome this. Inflation - The floating exchange rate can be inflationary. Apart from not punishing inflationary economies, which, in itself, encourages inflation, the float can cause inflation by allowing import prices to rise as the exchange rate falls. This is, undoubtedly, the case for countries such as UK where we are dependent on imports of food and raw materials.

Belarus

Managed Float Exchange Rate Regime

A managed floating rate systems is a hybrid of a fixed exchange rate and a flexible exchange rate system. In a country with a managed floating exchange rate system, the central bank becomes a key participant in the foreign exchange market. Managed float exchange rate policy is a control policy in which the exchange rate is generally allowed to adjust to equilibrium levels through to the interaction of supply and demand in the foreign exchange market, but with occasional intervention by government. Also termed as dirty float, most nations of the world currently use a managed flexible exchange rate policy. With this alternative an exchange rate is free to rise and fall, but it is subject to government control if it moves too high or too low, that is, the government steps into the foreign exchange market and buys or sells whatever currency is necessary keep the exchange rate within desired limits. Unlike in a fixed exchange rate regime, the central bank does not have an explicit set value for the currency. At the same time, it does not even allow the market to freely determine the value of the currency, as in the case of floating exchange rate regime. Instead, the central bank has either an implicit target value or an explicit range of target values for their currency. This is known as the currency band. The central bank intervenes in the foreign exchange market by buying and selling domestic and foreign currency to keep the exchange rate close to this desired implicit value or within the desired target values. For example, suppose that Thailand had a managed floating rate system and that the Thai central bank wants to keep the value of the Baht close to 25 Baht/$. In a managed floating regime, the Thai central bank is willing to tolerate small fluctuations in the exchange rate (say from 24.75 to 25.25) without getting involved in the market. If, however, there is excess demand for Baht in the rest of the market causing appreciation below the 24.75 level, the Central Bank increases the supply of Baht by selling Baht for dollars and acquiring holdings of U.S dollars. Similarly if there is excess supply of Baht causing depreciation above the 25.25 level, the Central Bank increases the demand for Baht by exchanging dollars for Baht and running down its holdings of U.S dollars. Therefore, under a managed floating regime, the central bank holds stocks of foreign currency which are known as foreign exchange reserves. It is important to realize that a managed float can only work when the implicit target is close to the equilibrium rate that would prevail in the absence of central bank intervention. Otherwise, the central bank will deplete its foreign exchange reserves and the country will be in a flexible exchange rate system because they can no longer intervene.

Q. Why do you think Central Banks might prefer a managed exchange rate system over a fixed or a floating exchange rate?
A. Managed exchange rate systems permit the government to place some influence on an exchange rate that would otherwise be freely floating. Managed means the exchange rate system has attributes of both systems. On one hand allowing one's currency to be dictated in its entirety by a foreign nation would be undesirable since exogenous shocks from the pegged country would affect your currency. There would be little control of the Central Bank to change expectations or impact the economy through a change in the exchange rate (thus impact interest rates through supply and demand for

domestic currency) as the entire exchange system would be dependent on the foreign nation's policies. The central bank will also be in a position to utilize monetary policy to its advantage, or essentially, the changes in monetary policy will have their desired effect on a market where the exchange is not fixed. Canada uses a managed exchange rate. They do not peg to the USD, and in fact permit the exchange rate to float so long as it remains with a certain target (which varies). If the CB doesn't like how much the dollar declines they can put in place measures to slow a depreciation or appreciation. However, the central banks power to change the exchange rate trend through the markets is usually limited as their influence cannot match the overall buying power of the global market.