To understand the concept of a managed floating exchange rate system, you have to understand what exchange rates are and how they function. An exchange rate regime is adopted by the top bank of any sovereign country to ideate, establish and operate a functioning exchange rate of its currency against foreign currency.
Most often, political, fiscal, and social issues determine a country’s exchange rate.
In India, the exchange rate regimen is governed by the Reserve Bank of India (RBI), often called the ‘Banker of Banks’. There are several types of exchange rate regimes, including managed float, free float, and a flexible exchange rate.
India follows a managed floating rate system. It gives a lot of independence to the market forces, provides data to regulators, and stabilizes India’s economy. Starting in 1991, when India’s economic policy underwent a renovation, and the markets opened to global companies, this regime has helped the country get back on its feet.
At first glance, a managed float system may not seem useful. However, economists and policy-makers have observed that since India needs to import certain essential items like crude oil, it is important for a Central Bank to maintain a tight leash on exchange rates.
That Central Bank is the RBI.
Before You Delve Deeper Into the Topic, Here is A Diy Task For You: Research on the last 4 Governors on the Internet. Look at their track records and their methods of management.
Managed Floating Exchange Rate Definition
In simple terms, a managed floating exchange rate is a system where currencies fluctuate daily but the regulatory authorities, including the government and the Reserve bank of India, may step in to control and stabilize the value of the currency.
If these bodies do not step in, there is bound to be an ‘economic shock’ to the country. As you know, India is a developing country with precise economic requirements. The GDP has been growing at a steady pace, and INR’s strength has increased over the last couple of years.
A managed floating exchange rate is occasionally called a ‘dirty float’ as opposed to a ‘clean float’ where central banks do not intervene.
According to numbers made public by the Reserve Bank of India, more than 40% of all countries use some sort of a managed floating regime. Without the guiding hand of Governments and their respective Central Banks, countries including Algeria, Argentina, Croatia, Egypt, Romania, Singapore, and Ukraine would face rising foreign exchange costs.
It can be safely said that a managed float is a hybrid control system. It is neither a free-float nor a flexible float exchange rate.
Why Does India Have a Floating Exchange Rate System?
The single most important rationale behind this lies in its history. You must remember that before 1991, India was not a globalized economy. Government offices were underperforming and suffering huge losses; there was rampant unemployment, and private enterprises were practically non-existent.
Table Below Lists the Chronology of Events Since Independence
Tasks for Advanced Commerce Students: Research about the Bretton-Woods Agreement and who the parties were. Noted economists and great thinkers like John Keynes and Harry White were present at the summit held in New Hampshire’s famous Mount Washington Hotel.
Find out why it broke down after 1971. You will also notice a return to similar lines of thinking after the 2008-09 global economic crisis.
Objectives of a Managed Floating System
Developing countries with high GDP growth rates usually prefer a managed floating exchange. Since there are bound to be geopolitical events beyond their control, such countries including India have placed a great deal of emphasis on this hybrid system. Here are the four main objectives of a dirty float.
To Reduce or Pause Exchange Rate Volatility: At times, the exchange rate of the US Dollar may go up against the INR. India will then have to pay more to buy crude oil and other essential commodities from the international market. The Rs 70/USD is considered a ‘psychologically significant mark’. If this is breached, both the Govt and the RBI will step in for corrective measures.
To preserve Adequate Forex Reserves: The BoP crisis of 1991 has not been forgotten. If such a scenario ever happened again, there would be enormous harm to India’s economy. A managed float ensures that India’s reserves have enough Foreign Exchange that can be sold at fair market prices during crises.
To Curb Speculative Activities: Speculation in foreign exchange and stock markets is not new. In fact, without speculation, such complex systems would not work. However, certain mala fide elements often carry out a series of rapid and successive speculations by buying or selling Forex in large volumes to make a quick profit. A managed floating exchange prevents such practices and ensures balance.
To Develop a Robust Forex Market: Despite the ‘Make in India’ and ‘Stand Up India’ schemes, the country still has to import a sizable range of products from overseas. To ensure fair competition and maintain adequate BoP, a managed floating exchange rate is necessary.
Advantages of a Managed Floating Regime
There are several merits of a managed float. Some crucial ones are:
A much stronger and more resilient monetary policy. Since the Central Bank and the Government work in tandem, there are little chances of differences in opinion at the very top. In India, the RBI has its own Monetary Planning Committee (MPC), formed under the RBI Act of 1934. This committee can alter interest rates if there are extenuating circumstances.
Once such discretionary measures are exercised, banks can alternatively pour in or squeeze out liquidity by giving loans.
The domestic economy is hardly impacted by the actions taken under a managed floating regime. It must be remembered that such a regime allows a high amount of autonomy to market forces to correct themselves, and the economy by extension. If this does not happen, the central agencies step in to make amends.
This 2-layered protection system had shielded India well in the 2008-09 crisis.
Disadvantages of a Managed Floating Regime
There are some demerits of a managed floating exchange rate system too. These are:
Competitive devaluations of currencies are the fallout of a managed regime. In a globalized world, more countries than ever before are vying for businesses and big enterprises to establish facilities in their nations. This competition has often led to intentional devaluation. Such phenomenons are often observed in South American countries.
Countries with a managed floating exchange often tend to have weaker financial systems. That is because the Central Banks and Governments have to be careful when drafting budgets and providing stimuli to slowing sectors. In India, there have been several complaints of weak fiscal policies. Various governments have been accused of not laying out a counter-cyclical budget.
For advanced students, it will be interesting to note that fixed and managed regimes share some disadvantages. It is partly due to the ability that countries with fixed exchange regimes can knowingly devalue their currency.
For more topics related to the senior secondary Commerce stream, you can make use of Vedantu’s study materials. Also, you can participate in our live interactive classes to gain a more profound understanding of challenging topics. You can refer to our learning programs to improve your self-study sessions.
What is Depreciation of a Currency?
Due to the ongoing operation of various market forces, the external value of a domestic currency may decrease causing what is known as depreciation. It means that the value of a given currency is less than the value of another foreign currency.
What is Appreciation of a Currency?
When the external value of a domestic currency increases because of the different market forces of demand and supply, it causes what is known as an appreciation. It means that the value of a given currency is more than the value of another foreign currency.
What is the Reason Behind the Central Bank’s Intervention in managing the Floating Rates of its Domestic Currency?
The central bank of a country might try different ways to depreciate the value of its domestic currency. Listed below are the different reasons for the depreciation of currency value:
To stabilize the current accounts which would improve the balance of trades by adding more price competition to its exports.
A depreciated currency would increase the demands of exports and make imports more expensive, due to which the price level inside the country would increase. This in turn would lower the risk of deflationary recession manifold.
If a country has seen a larger proportion of consumption than supply or exports or capital investments, the central bank would want to interfere in order to depreciate the value of the domestic currency which will result in an increase of exports bringing the economy to balance again.
The central bank might also try different ways to appreciate the value of its domestic currency. Below are listed the reasons for central bank intervention for appreciation of the value of domestic currency:
Appreciation can limit the demand-pull inflationary pressures.
Appreciation of the domestic currency can decrease the prices of imported products, technology, and capital, which will further cause long-term economic growth.
Another reason why the central bank of a country might want to intervene in managing the external value of its domestic currency is to decrease the volatility- which is the degree of change of various trading prices over a period of time- of market exchange rates. It does this to gain back the confidence of big businesses and important investors, which might weaken because of great fluctuations in the market forces. For instance, if some foreign investor's risk, who is planning on buying a government’s bonds increases due to this fluctuation, they will want a higher interest rate on these bonds as a form of compensation for the increased risk.
What are the other Types of Exchange Rates?
Apart from the managed floating exchange rates, there are three other types of exchange rate systems that are identified by the IMF and are applicable in different countries. Let us look at these different types of exchange rates:
Fixed Exchange Rate System- This is also called the pegged exchange rate system and does not depend on the fluctuations of market forces at all. Out of the two currencies which are considered, the weaker currency is pegged with the stronger currency by either the government or the central bank of the domestic country through the purchase of foreign exchange.
Flexible Exchange Rate System- The flexible exchange rate system is also commonly known as the floating exchange rate system. It is flexible or floating because it solely depends on the market forces of demand and supply. Any intervention of the government or central banks is not possible to influence the value of the currency.
FAQs on What Is Managed Floating Exchange Rate System?
1. What is a managed floating exchange rate system as per the CBSE Class 12 Economics syllabus?
A managed floating exchange rate system is a hybrid framework that combines elements of both a fixed and a flexible exchange rate system. In this system, the currency's value is primarily determined by market forces of supply and demand. However, the country's central bank, like the Reserve Bank of India (RBI), periodically intervenes by buying or selling foreign currencies to manage excessive volatility and steer the exchange rate in a desired direction.
2. How does a managed float differ from a free-floating exchange rate?
The key difference lies in the level of government intervention. In a free-floating (or clean float) system, the exchange rate is determined exclusively by market forces without any central bank intervention. In a managed float (or dirty float) system, while market forces are dominant, the central bank actively intervenes to prevent extreme fluctuations and maintain economic stability.
3. Why is the managed floating system often called a 'dirty float'?
The term 'dirty float' is used informally to describe the managed floating system because it is not a 'clean' or pure float. The 'dirt' refers to the intervention by the central bank, which 'muddies' the pure market-driven determination of the exchange rate. It highlights that the currency is not floating freely but is being influenced or managed behind the scenes.
4. What are the main objectives of a central bank's intervention in a managed float system?
A central bank intervenes in a managed float system with several key objectives, including:
- To curb excessive volatility and speculation in the foreign exchange market.
- To prevent the domestic currency from appreciating or depreciating too rapidly, which could harm exports or imports.
- To maintain a stable and predictable environment for international trade and investment.
- To accumulate or preserve the nation's foreign exchange reserves.
5. What are the principal advantages and disadvantages of a managed floating exchange rate?
The managed floating system has distinct pros and cons. Advantages include:
- It offers flexibility for the exchange rate to adjust to economic shocks while preventing extreme instability.
- It gives the central bank some control over monetary policy, unlike a purely fixed system.
- It helps avoid the currency misalignments that can occur under a fixed rate.
- It requires the central bank to hold substantial foreign exchange reserves to be effective.
- It can be difficult to determine the 'correct' level for the exchange rate, leading to policy errors.
- The central bank's actions can sometimes be outmatched by the sheer volume of the global foreign exchange market.
6. How does India apply the managed floating exchange rate system?
India officially follows a managed floating exchange rate system. The Reserve Bank of India (RBI) does not target a specific exchange rate for the Indian Rupee (INR). Instead, it monitors the market and intervenes by buying or selling US dollars to smoothen volatility. The RBI's goal is not to fix the price but to ensure orderly conditions in the foreign exchange market, preventing disruptive movements that could negatively impact the economy.
7. What factors can limit a central bank's power to influence currency value in a managed float system?
Several factors can constrain a central bank's ability to manage its currency effectively:
- Insufficient Foreign Reserves: Intervention requires large amounts of foreign currency, which may be limited for some nations.
- Scale of Global Markets: The daily volume of the global forex market is immense and can easily overwhelm the resources of a single central bank.
- Conflicting Policy Goals: Actions to manage the currency, such as changing interest rates, might conflict with domestic macroeconomic objectives like promoting growth or controlling inflation.
8. Can you give some real-world examples of countries that use a managed floating exchange rate?
Yes, many countries around the world use a form of managed floating exchange rate. Besides India, other notable examples include Singapore, Brazil, South Africa, and Mexico. The level and frequency of intervention vary significantly among these nations based on their specific economic policies and goals.
