Limited Flexibility Exchange Rate System - Explained
What is the Limited Flexibility Exchange Rate System?
Written by Jason Gordon
Updated at June 29th, 2021
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Table of Contents
What is the Limited Flexibility Exchange Rate System?The Policy Players in an Exchange Rate SystemHow A Managed Exchange Rate System WorksAcademic Research on the Managed Exchange Rate SystemWhat is the Limited Flexibility Exchange Rate System?
The International Monetary Fund's name for an exchange rate system with a managed float is the Limited Flexibility Exchange Rate System. A flexible exchange-rate system is a monetary system that allows the exchange rate to be determined by supply and demand. Every recognized sovereign creating a currency must decide what type of exchange rate arrangement to maintain. Between permanently fixed and completely flexible are several heterogeneous approaches. They have different implications for the extent to which national authorities participate in foreign exchange markets. A Limited Flexibility Exchange Rate System is an exchange rate control policy in which an exchange rate that is generally allowed to adjust to equilibrium levels through to the interaction of supply and demand in the foreign exchange market, but with occasional intervention by government. Also termed managed float or dirty float, most nations of the world currently use a managed flexible exchange rate policy. With this alternative an exchange rate is free to rise and fall, but it is subject to government control if it moves too high or too low. With managed float, the government steps into the foreign exchange market and buys or sells whatever currency is necessary keep the exchange rate within desired limits. This is one of three basic exchange rate policies used by domestic governments. The other two policies are flexible exchange rate and fixed exchange rate. 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.
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The Policy Players in an Exchange Rate System
A managed flexible exchange rate policy is the policy of choice among most nations of the world. A few smaller nations fix their exchange rates to that of larger, stable nations as a means of assuring their own stability. But most allow their exchange rates to fluctuated through market forces within specified limits. When policy intervention is needed, it is undertaken by two types of players -- central banks and international agencies.
How A Managed Exchange Rate System Works
Foreign exchange markets are essentially "over-the-counter" markets, with buyers and sellers located around the globe. Central banks and the International Monetary Fund regularly monitor the exchange rates negotiated among the currency buyers and sellers. 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.
Academic Research on the Managed Exchange Rate System
- The modern history of exchange rate arrangements: a reinterpretation, Reinhart, C. M., & Rogoff, K. S. (2004). The modern history of exchange rate arrangements: a reinterpretation. the Quarterly Journal of economics, 119(1), 1-48. This journal explains the different modern currency exchange rate systems with the help of studies and posits different classifications for them.
- The determinants of the choice between fixed and flexible exchange-rate regimes, Edwards, S. (1996). The determinants of the choice between fixed and flexible exchange-rate regimes (No. w5756). National Bureau of Economic Research. This paper attempts to explain the different reasons and factors that determine the kind of currency system adopted by different nations.
- The case for flexible exchange rates, 1969, Johnson, H. G. (1969). The case for flexible exchange rates, 1969. Federal Reserve Bank of St. Louis Review, (June 1969). This book makes the case for the adoption of flexible exchange rates system.
- The theory of flexible exchange rate regimes and macroeconomic policy, Dornbusch, R. (1976). The theory of flexible exchange rate regimes and macroeconomic policy. The Scandinavian Journal of Economics, 255-275. This paper examines the effect of flexible exchange rate systems on economic equilibrium and presents three different perspectives.
- Exchange rate regimes: is the bipolar view correct?, Fischer, S. (2001). Exchange rate regimes: is the bipolar view correct?. Journal of economic perspectives, 15(2), 3-24. This paper argues that the two-corner exchange rate solution is overstated and posits that its sustainability in the long term is suspect.
- Financial turmoil and the choice of exchange rate regime, Hausmann, R., Gavin, M., Pages-Serra, C., & Stein, E. (1999). Financial turmoil and the choice of exchange rate regime. Wanted: world financial stability. This book discusses the economic turmoil in Latin America and examines what the role of the choice of exchange rates system is in this scenario.
- The mirage of exchange rate regimes for emerging market countries, Calvo, G. A., & Mishkin, F. S. (2003). The mirage of exchange rate regimes for emerging market countries. Journal of Economic Perspectives, 17(4), 99-118. This paper discusses and deconstructs all the conventional approaches to choosing a currency exchange system. Instead it advocates institutional reforms for healthier economies.
- Terms of trade and exchange rate regimes in developing countries, Broda, C. (2004). Terms of trade and exchange rate regimes in developing countries. Journal of International economics, 63(1), 31-58. This book studies the effect of different exchange rate systems in 75 developing economies and analyses how the results live up to Friedmans hypothesis.
- Flexible exchange rates and the theory of employment, Laursen, S., & Metzler, L. A. (1950). Flexible exchange rates and the theory of employment. The Review of Economics and Statistics, 281-299. This paper takes a critical look at flexible exchange rate systems and their ascertained impact on national employment levels in different countries.
- Flexible exchange rates, prices and the role of 'news': Lessons from the 1970s, Frenkel, J. A. (1982). Flexible exchange rates, prices and the role of news: Lessons from the 1970s. In Exchange Rate Policy (pp. 48-100). Palgrave Macmillan, London. This book takes a look at the post Bretton Woods flexible exchange rates systems adopted across the globe and the role of news in influencing these exchange markets.
- On becoming more flexible: exchange rate regimes in Latin America and the Caribbean, Collins, S. M. (1996). On becoming more flexible: exchange rate regimes in Latin America and the Caribbean. Journal of Development Economics, 51, 117-138. This paper takes a close look at the flexible exchange rate systems and their impact in Latin America and the Caribbean.