Question

How do managed floating exchange rates operate? Why were they adopted by the industrialized nations in 1973?

Short answer

Managed floating exchange rates operate based on the forces of supply and demand in the foreign exchange market but with potential interventions from the country's central bank to stabilize the exchange rate. They were adopted by the industrialized nations in 1973 due to the need for more flexibility and instability of the U.S. dollar under the previously existing fixed exchange rate framework of the Bretton Woods Agreement.

Step-by-step solution

Understanding Managed Floating Exchange Rates

Managed floating exchange rate is a type of exchange rate regime where a country's currency value is determined in the foreign exchange market, where supply and demand for a currency basically determine its value. However, the country's monetary authority, such as a central bank, can intervene to 'manage' the exchange rate. This is done to prevent fluctuations that could be harmful to the economy, by buying or sell its own currency in the international market to smooth out market fluctuations in exchange rates and stabilize their currency.

The Adoption of Managed Floating Exchange Rates in 1973

In 1973, most industrialized nations moved to the system of managed floating exchange rates, abandoning the system of fixed exchange rates established by the Bretton Woods Agreement in 1944. This change was primarily due to the inability of the U.S. to keep up with the system's requirement for gold and U.S. dollars to back currencies. The value of the dollar was seen as unstable and there were concerns about the U.S.'s ability to maintain the value of the dollar.

Reasons for The Adoption of Managed Floating Exchange Rates

The decision to adopt a managed floating exchange rate system was driven by a desire for more flexibility. This system would allow every country's currency to change in value relative to other currencies, which is determined by supply and demand in the international foreign exchange market. This allows for adjustments in a country's money supply and provides policy flexibility, which can help support economic stability. The managed float system also provides a cushion against economic shocks.

Key concepts

Exchange Rate Regime

An exchange rate regime is the way a country manages its currency in relation to other currencies and the foreign exchange market. It encompasses how a country's currency is valued and determines the systems and rules governing the exchange rate of its currency against others.

There are various types of exchange rate regimes, which include fixed exchange rates, where a currency's value is pegged to another major currency or a basket of currencies; floating exchange rates, where the market dictates the currency's value; and managed floating exchange rates, which are a hybrid of both.

In a managed floating regime, the currency's value is primarily determined by market forces, but the monetary authority has the discretion to intervene to stabilize currency fluctuations. This is key to maintaining economic certainty while allowing some flexibility for the currency to respond to market conditions.

Bretton Woods Agreement

The Bretton Woods Agreement was established in 1944 as part of a post-war plan to create a stable global economic environment. Named after the location of the conference in New Hampshire, USA, where it was negotiated, the agreement resulted in fixed exchange rates where currencies were pegged to the U.S. dollar, and the dollar was convertible into gold at a fixed rate.

This system was designed to prevent competitive devaluations which had contributed to economic turmoil in the pre-war years. However, the U.S. dollar's stability became questionable in the 1960s, leading to the suspension of gold convertibility and paving the way for a new system of exchange rates by the early 1970s.

Foreign Exchange Market

The foreign exchange market, also known as the Forex or FX market, is a global decentralized or over-the-counter marketplace where currencies are traded. It is the largest financial market in the world, operating 24 hours a day, five days a week, and involves a vast array of participants from central banks to individual investors.

The foreign exchange market is responsible for setting the value of different currencies. Prices in this market are influenced by a multitude of factors, including economic data, political events, and market sentiment. Managed floating exchange rates take advantage of the naturally occurring market dynamics while giving countries the flexibility to adjust their economic policies as needed.

Economic Stability

Economic stability refers to a state where an economy experiences constant growth and minimal fluctuation in key metrics like employment rates, price levels, and output. It's critical for businesses' operations, consumer confidence, and overall societal well-being.

Managed floating exchange rates can contribute to economic stability by allowing currency values to adjust in response to external economic shocks. It provides a balance by letting market forces dictate currency values while enabling governments to step in to quell excessive volatility that might disrupt economic stability.

Monetary Authority Intervention

Monetary authority intervention occurs when a country's central bank or similar institution actively buys or sells its own currency in the foreign exchange market to influence its value. The aim of this intervention is to stabilize or alter the exchange rate to achieve economic objectives.

Under a managed floating exchange rate system, a monetary authority may intervene to smoothen out sharp fluctuations in the currency, ensuring that the exchange rate movements do not disrupt the country's economic policies and goals. These interventions can include various monetary tools and foreign market operations, often perceived as a safeguard against irregular and potentially damaging market forces.