determination of exchange rates under fixed and managed systems

💱 Exchange Rates – Fixed & Managed Systems

In this lesson we’ll learn how exchange rates are set when a country chooses a fixed or a managed (managed‑float) system. We’ll use simple analogies, clear examples, and a few exam‑ready tips.

🔹 Fixed Exchange Rate System

In a fixed system the government or central bank sets the value of its currency against another currency (or a basket of currencies) and keeps it stable.

Think of it like a price tag on a toy that never changes. If the UK pegged the pound to the euro at 1 £ = 1.2 €, the pound’s value is “locked” at that rate.

  1. Central bank announces the peg.

  2. It buys or sells foreign currency to keep the rate at the target.

  3. Market forces (demand/supply) are offset by the bank’s interventions.

Key formula (simplified): \$E = \frac{P{\text{dom}}}{P{\text{for}}}\$ where \$P{\text{dom}}\$ is domestic price level and \$P{\text{for}}\$ is foreign price level.

FeatureFixed SystemFloating System
Exchange Rate DeterminationSet by central bankMarket forces
Policy FlexibilityLow – must maintain pegHigh – can adjust via interest rates
Risk of DevaluationHigh if reserves lowLow – market absorbs shocks

Exam Tip: When asked to compare fixed and floating systems, list advantages (e.g., stability, low inflation) and disadvantages (e.g., loss of monetary policy autonomy) for each. Use the table above as a quick reference.

🔹 Managed (Managed‑Float) Exchange Rate System

In a managed float the currency is mainly market‑determined but the central bank occasionally intervenes to smooth extreme moves.

Imagine a tightrope walker who usually follows the rope (market) but occasionally uses a safety net (intervention) to avoid falling.

  1. Currency floats freely in most circumstances.

  2. Central bank sells or buys currency when the rate moves outside a target band.

  3. Intervention is usually limited to maintain confidence, not to set a fixed rate.

Example: China’s yuan is managed against the US dollar. The People’s Bank of China intervenes to keep the yuan within a narrow range, but the rate still fluctuates within that band.

FeatureManaged FloatFixed
Exchange Rate DeterminationMarket with occasional interventionSet by central bank
Policy FlexibilityModerate – can adjust within bandLow – must maintain peg
Risk of DevaluationModerate – intervention limits but does not eliminateHigh if reserves insufficient

Exam Tip: For a managed float, emphasise that the rate is mainly market‑driven but the central bank uses intervention to keep it within a target band. Highlight the trade‑off between stability and policy autonomy.

📌 Quick Review & Exam Checklist

  • Fixed rate: Stability, low inflation, loss of monetary policy autonomy.

  • Managed float: Market‑driven with limited intervention, moderate stability, better policy flexibility.

  • Use the table comparison to structure answers.

  • Remember the formula for purchasing power parity: \$E = \frac{P{\text{dom}}}{P{\text{for}}}\$.

  • When asked about intervention, explain the role of foreign reserves and the central bank’s objective (e.g., preventing excessive volatility).