Managed Floating Exchange Rate System : Meaning, Objectives, Merits and Demerits

A medium of exchange for goods and services is called currency, which is different from one country to another country. However, a country’s currency cannot be used in another country. For this purpose, the currency of one country is converted into the currency of another country, and the rate at which one currency is exchanged for another is called the Foreign Exchange Rate. Foreign exchange rates can be classified into various types. One of them is Managed Floating Exchange Rate System. Managed Floating Exchange Rate System is determined both by the market forces and the Central Bank.

What is Managed Floating Exchange Rate System?

Managed Floating Exchange Rate System is the combination of the fixed rate system (the managed part) and the flexible rate system (the floating part), thus, it is also called a Hybrid System. It refers to the system in which the foreign exchange rate is determined by the market forces and the central bank stabilizes the exchange rate in case of appreciation or depreciation of the domestic currency.

Geeky Takeaways:

• Under this system, the central bank acts as a bulk buyer or seller of foreign exchange to control the fluctuation in the exchange rate. The central bank sells foreign exchange when the exchange rate is high to bring it down and vice versa. It is done for the protection of the interest of importers and exporters.
• For this purpose, the central bank maintains the reserves of foreign exchange so that the exchange rate stays within a targeted value.
• If a country manipulates the exchange rate by not following the rules and regulations, then it is known as Dirty Floating. 
• However, the central bank follows the necessary rules and regulations to influence the exchange rate.

Example of Managed Floating Exchange Rate

Suppose, India has adopted Managed Floating System and the Reserve Bank of India (Central Bank) wants to keep the exchange rate $1 = ₹60. And, let’s assume that the Reserve Bank of India is ready to tolerate small fluctuations, like from 59.75 to 60.25; i.e., .25.
If the value remains within the above limit, then there is no intervention. But if due to excess demand for the Indian rupee the value of the rupee starts declining below 59.75/$. Then, in that case, RBI will start increasing the supply of rupees by selling the rupees for dollars and acquiring holding of dollars.
Similarly, due to the excess supply of the Indian rupee, if the value of the rupee starts increasing above 60.25/$. Then, in that case, RBI will start increasing the demand for Indian rupees by exchanging the dollars for rupees and running down its holding of dollars.
Hence, in this way, the Reserve Bank of India maintains the exchange rate.

Objectives of Managed Floating Exchange Rate System

Managed Floating Exchange Rate System fulfills the objectives that are important for the smooth running of markets. Some of the objectives fulfilled by managed floating exchange rate system are:

1. Lower down the Volatility: Managed Floating Exchange Rate System helps in controlling the volatility which is caused due to market forces. Volatility in the exchange rate should not be left untreated because it can cause an increase in prices even for essential commodities.
2. Ensures Sufficient Foreign Exchange: Managed Floating Exchange Rate System ensures that the country has sufficient foreign exchange which can be sold at the time of crisis.
3. Prevents Speculations: Managed Floating Exchange Rate System ensures that there is a restriction against rapid and increasing speculations that are caused due to buying and selling of foreign exchange in order to earn profits.
4. Ensures Adequate BOP: Managed Floating Exchange Rate System ensures that the country is maintaining an adequate and fair balance of payment accounts.

Advantages of Managed Floating Exchange Rate System

Managed Floating Exchange Rate System provides advantages in operating the market as well as depicts some important points related to the market and country. Some of the pros are:

1. Balanced Monetary Policy: Managed Floating Exchange Rate System helps the country in maintaining a balanced monetary policy as it involves both the central bank and the government.
2. Flexibility: Managed Floating Exchange Rate System does not affect the domestic economy. It gives leniency to market forces to correct themselves and the economy by extension.
3. Market Signals: Managed Floating Exchange Rate System reflects the prevailing conditions of the market and depicts the country’s economic health.
4. Trade Balance Adjustment: Managed Floating Exchange Rate System helps to correct the trade imbalance by allowing currency appreciation or depreciation.
5. Prevents Speculations: Managed Floating Exchange Rate System ensures that there is a restriction against rapid and increasing speculations that are caused due to buying and selling of foreign exchange in order to earn profits.

Disadvantages of Managed Floating Exchange Rate System

Though Managed Floating Exchange Rate System offers so much leniency and advantages to the market, it still has some drawbacks. Some of the drawbacks are:

1. Volatility: Despite of Managed Floating Exchange Rate System, exchange rates can still be volatile, which introduces uncertainty for businesses and investors.
2. Limited Control: Central banks can invade in the determination of exchange rates under Managed Floating Exchange Rate System but up to some extent only.
3. Vulnerability: Managed exchange rates can still be vulnerable and affected due to the manipulation of market participants.
4. Lack of Coordination: Managed Floating Exchange Rate System can cause disputes between countries due to a lack of coordination and communication while setting the managed exchange rate.