In contrast to the fixed exchange rate regime, the flexible exchange rate system encompasses various forms of exchange rate regimes that allow the exchange rate of two nations to be determined by the demand and supply of the currencies in the foreign exchange market. The term floating exchange rate is also used to describe the general form of the flexible exchange rate in the system. In principle, the flexible exchange rate system is driven by a free market force while allowing some variations of central bank intervention. Major forms of exchange rate regimes under the flexible exchange rate system include freely floating (or clean floating) and managed floating (or dirty floating). In some cases, adjustable peg and crawling peg are also considered part of the flexible exchange rate system.
In the early 1970s, countries with major currencies, such as the United States, began to adopt a flexible rate system after the collapse of the Bretton Woods system, under which a fixed or pegged exchange rate regime prevailed. Though the majority of the developing nations still remained on the fixed exchange rate at the time, many had shifted to more flexible exchange rate systems such as the adjustable peg, crawling peg, and managed floating exchange rate systems.
What caused the movement from a fixed to a more flexible exchange rate system in this 20-year period for the emerging markets, though via a gradual process, were (1) sharp changes in value in major currencies that these nations tied their currencies to, (2) slower growth of more developed nations that launched opportunity seeking in the developing nations, (3) steep rise in the interest rate worldwide that encouraged a more flexible exchange rate system, (4) debt crisis as a result of overexpansion or huge capital inflow that put pressure on local currencies, and (5) inflation problems that called for changes in monetary policy that are more suited for a flexible exchange rate regime. In short, during these volatile times, a more flexible exchange rate regime was demanded for countries under fixed exchange rate regimes to adapt quickly and to be able to survive in the international trade and investment market. In other words, as the financial market globalized and the developing economies were more closely integrated with those of the more developed, the international exchange rate system had moved toward forms that allow nations to work more cooperatively and efficiently.
Though quite a few developing countries shifted to a more flexible exchange rate system after the mid-1990s, many still adopted the system with various degrees of control through central bank intervention or managed floating. This trend was due to the nations’ smaller economies and relatively thin financial markets that were intolerant of extreme volatilities. In addition, many of these nations depend heavily on their exports or imports, and any big swings in their foreign exchange rates could cause serious imbalances in their balance of payments (e.g., a sudden depreciation in a nation’s currency accompanied by a large import would cause a huge increase in its deficit in balance of payments).
However, in terms of the effect of the flexible exchange rate system on the domestic economy, and compared with that of the fixed exchange rate regime, the flexible exchange rate is more suitable when there are large inflows of capital transmitted to a developing economy. In China’s case and in order to achieve stability in its economy, given the size and speed of its growth in the past 20 years, a crawling peg or managed floating exchange rate regime is more appropriate when its market is inundated with large inflows of capital. In other words, a crawling peg or managed floating exchange rate regime is more apt to alleviate the upward pressure for its currency to appreciate in a progressive manner. And in many cases, a specific form of the flexible exchange rate, e.g., managed floating, that is adopted by the central bank and is believed to be the most appropriate at the time usually work in synchronization with a nation’s economy at a particular development stage. While the freely floating exchange rate may contribute to inflation at times, proper use of the monetary policy, such as interest rate increasing, will not only address the inflation problem but also encourage imports, one of the auto correction responses from the market that further reduces inflation pressure.
Nonetheless, the flexible exchange rate system, with various degrees of government intervention, still requires a nation to be equipped with an adept regulatory establishment, a solid banking structure and supervision, and a free market that permits free information transmission to pave the way for the system to work efficiently and well.
- Francesco Caramazza and Jahangir Aziz, Fixed or Flexible? Getting the Exchange Rate Right in the 1990s (IMF, April 1998);
- Jose De Gregorio and Andrea Tokman, Flexible Exchange Rate Regime and Forex Interventions: The Chilean Case (Banco Central de Chile, 2004);
- Domenico Fanizza, Tunisia’s Experience with Real Exchange Rate Targeting and the Transition to a Flexible Exchange Rate Regime (International Monetary Fund, 2002);
- -J. Jo, “Changes in Misalignment of the Korean Won: Towards a Flexible Exchange Rate Regime,” Global Economic Review (v.33/1, 2004);
- Sayera Younus, and Mainul Islam Chowdhury. An Analysis of Bangladesh’s Transition to Flexible Exchange Rate Regime (Bangladesh Bank, 2006).
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