A managed float exchange rate policy is much like a mother who allows her young son to play outside but does not allow him to leave the backyard. Freely playing in the backyard is the flexible part and not leaving the backyard is the managed/fixed part.

This policy evolved from the historical inclination of most nations to fix exchange rates, which was then countered with the theoretical benefits of unrestricted flexible exchange rates. Nations have been prone to fix exchange rates above equilibrium levels as a means of encouraging exports and discouraging imports. But this strategy cannot be simultaneously undertaken by all nations and is usually detrimental to global trade.

A flexible exchange rate policy is generally more efficient and lessens the likelihood of global trade conflicts. However, problems can occur if exchange rates rise or fall substantially in a short period. As such, governments step in to limit exchange rate changes, keeping them within "acceptable" bounds, keeping them from leaving the backyard where they might run into a street and be injured by a moving vehicle.

The Policy Players

When policy intervention is needed, it is undertaken by two types of players -- central banks and international agencies.

• Central Banks: The primary players in most managed exchange rate policies are one or both of the governments issuing the currency being exchanged. The specific policy decision makers are usually the central banks of the countries. A central bank might operate independently or in cooperation with the central bank of another nation. For example, the Federal Reserve System keeps a close eye on exchange rates between the U.S. dollar and the currencies of other nations, taking actions when deemed necessary. However, it often works with the Bank of England, the Bank of Japan, and other central banks to keep the dollar-pound, dollar-yen, and other exchange rates under control.


• International Agencies: Other major players managing exchange rates are international agencies, especially the International Monetary Fund (IMF). The IMF is an agency chartered by the United Nations specifically charged with monitoring and stabilizing foreign exchange rates. It has stockpiles of the currencies of member nations (over 150) that it uses when needed to manage exchange rates. Should the Mexican peso fall abruptly relative to the Brazilian real, then the IMF might step into the fray and buy a few Mexican pesos and sell a few Brazilian reals.

How it Works

With a managed float, the foreign exchange markets carry on normal day-to-day activity as exports, imports, investors, and speculators buy and sell the currencies needed to conduct their business activities. If, however, an exchange rate looks to be rising or falling too much, moving outside the range that the policy players deem acceptable, then they are likely to step into the fray, doing whatever buying and selling of currency is necessary to keep the exchange within bounds.

Suppose, for example, that the United States, Britain, and the International Monetary Fund have decided that an exchange rate between 1.9 and 2.1 U.S. dollars per British pound is suitable for maintaining a stable global economy.

• Too High: If the exchange rate rises to say 2.2 dollars per pound, outside the targeted range, then one or more of the policy makers is inclined to take action. In this case, the British central bank, Bank of England, might sell a few British pounds and buy a few U.S. dollars. By adding pounds and taking away dollars, the exchange rate of dollars per pounds decreases.


• Too Low: Alternatively, if the exchange rate falls to something like 1.8 dollars per pound, then reverse action is in order. In this case, the U.S. central bank, the Federal Reserve, might sell a few U.S. dollars and buy a few British pounds. By adding dollars and taking away pounds, the exchange rate of dollars per pounds increases.

Two Other Exchange Rate Policies

• Flexible Exchange Rate: A flexible exchange rate, also termed floating exchange rate, is an exchange rate determined through the unrestricted interaction of supply and demand in the foreign exchange market. A flexible exchange rate means that a country is NOT trying to manipulate currency prices to achieve some change in the exports or imports. This policy is based on the presumption that the free interplay of market forces is most likely to generate a desireable pattern of international trade.


• Fixed Exchange Rate: A fixed exchange rate is an exchange rate that is established at a specific level and maintained through government actions (usually through monetary policy actions of a central bank). To fix an exchange rate, a government must be willing to buy and sell currency in the foreign exchange market in whatever amounts are necessary to keep the exchange rate fixed. A fixed exchange rate typically disrupts the balance of trade and balance of payments for a country. But in many cases, this is exactly what a country is seeking to do.