7.2 Managed float and currency boards

Exchange rate systems play a crucial role in international economics. Managed float and currency boards are two approaches countries use to balance stability and flexibility in their currency values. These systems impact a nation's monetary policy, trade competitiveness, and economic resilience.

Understanding the pros and cons of each system is key for policymakers. Managed floats offer some flexibility, while currency boards provide strict stability. Both aim to maintain currency value and economic stability, but differ in their approach to market forces and monetary control.

Exchange Rate Systems

Managed float exchange rate system

Top images from around the web for Managed float exchange rate system

• 

  Exchange-Rate Policies | Macroeconomics View original

  Is this image relevant?

• 

  Reading: Exchange-Rate Policies | Macroeconomics View original

  Is this image relevant?

• 

  Exchange Rate Policies | OpenStax Macroeconomics 2e View original

  Is this image relevant?

• 

  Exchange-Rate Policies | Macroeconomics View original

  Is this image relevant?

• 

  Reading: Exchange-Rate Policies | Macroeconomics View original

  Is this image relevant?

1 of 3

Top images from around the web for Managed float exchange rate system

• 

  Exchange-Rate Policies | Macroeconomics View original

  Is this image relevant?

• 

  Reading: Exchange-Rate Policies | Macroeconomics View original

  Is this image relevant?

• 

  Exchange Rate Policies | OpenStax Macroeconomics 2e View original

  Is this image relevant?

• 

  Exchange-Rate Policies | Macroeconomics View original

  Is this image relevant?

• 

  Reading: Exchange-Rate Policies | Macroeconomics View original

  Is this image relevant?

1 of 3

• Managed float is an exchange rate system where the currency's value is determined by market forces (supply and demand), but the central bank intervenes to influence the exchange rate
  • Interventions aim to minimize excessive fluctuations and maintain stability (smooth out volatility)
• Key features of managed float systems:
  • Exchange rate is not fixed to another currency (USD) or commodity (gold)
  • Central bank sets a target range for the exchange rate (±2% from the central parity)
  • Interventions occur when the exchange rate moves outside the target range (buying or selling foreign currency reserves)
• Objectives of managed float systems:
  • Maintain relative stability in the exchange rate (prevent sharp appreciations or depreciations)
  • Prevent excessive appreciation or depreciation of the currency (maintain competitiveness)
  • Provide flexibility to adjust to economic shocks (global financial crisis) and market conditions (changes in interest rates)

Currency boards for monetary stability

• Currency boards are monetary authorities that issue domestic currency backed by a foreign reserve currency at a fixed exchange rate
  • Domestic currency is fully convertible into the reserve currency (1:1 ratio)
• Key functions of currency boards:
  • Maintain a fixed exchange rate between the domestic currency and the reserve currency (pegged exchange rate)
  • Ensure full convertibility of the domestic currency into the reserve currency (no restrictions on currency exchange)
  • Hold foreign exchange reserves equal to or greater than the amount of domestic currency in circulation (100% or more backing)
• Currency boards promote monetary stability by:
  • Eliminating the possibility of discretionary monetary policy (no control over money supply)
  • Requiring the currency board to maintain sufficient foreign reserves (ensure credibility of the peg)
  • Providing credibility to the fixed exchange rate commitment (anchor for inflation expectations)

Managed float vs currency boards

• Similarities between managed float systems and currency boards:
  • Both aim to maintain stability in the exchange rate (reduce volatility)
  • Both involve some level of intervention in the foreign exchange market (buying or selling foreign currency)
• Differences between managed float systems and currency boards:
  • Exchange rate flexibility:
    • Managed float allows for some flexibility in the exchange rate within a target range (adjustable peg)
    • Currency boards maintain a strict fixed exchange rate (hard peg)
  • Monetary policy autonomy:
    • Managed float systems retain some degree of monetary policy autonomy (control over interest rates)
    • Currency boards eliminate discretionary monetary policy (interest rates determined by the reserve currency country)
  • Foreign exchange reserves:
    • Managed float systems do not require full backing of the domestic currency by foreign reserves (partial backing)
    • Currency boards require 100% or more backing of the domestic currency by foreign reserves (full backing)
• Advantages of managed float systems:
  • Provide flexibility to adjust to economic shocks (terms-of-trade shocks) and market conditions (capital flows)
  • Allow for some degree of monetary policy autonomy (control over interest rates and money supply)
• Limitations of managed float systems:
  • Require active management and intervention by the central bank (foreign exchange market operations)
  • May be subject to speculative attacks if the target range is not credible (currency crisis)
• Advantages of currency boards:
  • Provide credibility to the fixed exchange rate commitment (anchor for inflation expectations)
  • Promote monetary stability by eliminating discretionary monetary policy (rule-based monetary policy)
• Limitations of currency boards:
  • Require sufficient foreign exchange reserves to maintain the fixed exchange rate (vulnerability to reserve depletion)
  • Limit the ability to respond to economic shocks through monetary policy (no control over interest rates)

Effectiveness of exchange rate arrangements

• Managed float systems have been adopted by several countries, such as:
  • Singapore: The Monetary Authority of Singapore manages the Singapore dollar against a basket of currencies, allowing for gradual appreciation to control inflation (price stability)
  • India: The Reserve Bank of India intervenes in the foreign exchange market to prevent excessive volatility in the Indian rupee (exchange rate stability)
• Currency boards have been implemented in countries like:
  • Hong Kong: The Hong Kong Monetary Authority maintains a fixed exchange rate between the Hong Kong dollar and the US dollar, backed by foreign exchange reserves (credibility)
  • Bulgaria: The Bulgarian National Bank operates a currency board, pegging the Bulgarian lev to the euro (monetary stability)
• Effectiveness of managed float systems:
  • Can help maintain competitiveness and stability in the face of economic shocks (global financial crisis)
  • Requires careful management and credibility of the central bank to prevent speculative attacks (currency crisis)
• Effectiveness of currency boards:
  • Can provide stability and credibility in countries with a history of monetary instability (hyperinflation)
  • May limit the ability to respond to economic shocks (asymmetric shocks) and can be vulnerable to changes in the reserve currency (USD appreciation)