Limited Flexibility Exchange Rate System Definition
A flexible exchange rate system where the value of a currency relative to other currencies, is decided by its supply and demand in the market, is called a floating system of exchange. When this system is limited or managed, with imposed conditions and limitations on the float, it’s called a Limited Flexibility Exchange Rate System.
A Little More on What is the Limited Flexibility Exchange Rate System
Depending on the participation of national authorities in the foreign currency exchange markets, there are three different categories of exchange rates systems:
- Fixed Rate Regimes
- Intermediate Regimes
- Flexible Regimes
Limited Flexibility Exchange Rate system falls under the Flexible Regimes category consisting of managed as well as independent floats. As a managed float, exchange rates are still determined by supply and demand in a LFER system but there’s occasional governmental intervention to introduce price corrections when values fluctuate wildly, or to maintain the currency within a set range of values. It’s one of the most widely used exchange rate systems across the globe.
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 amount of currency is necessary, to 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 a fixed exchange rate.
A managed float maintains the illusion of a flexible exchange rate system even as it is managed by governments behind the scenes.
Exchange Rate System Policy Players
A managed or dirty float is the preferred exchange rate system of most nations. Some smaller nations might choose to go with Fixed Rates System or tie up their exchange rates with those of larger nations to stabilize their currencies. But most go with the managed system in order to exercise greater control on their currencies. Central Banks and International Agencies are the policy players that intervene in currency exchange systems to influence the value of a currency.
How Does a Managed Exchange Rate System Work?
Currency trading happens over the counter on a regular basis in Foreign Exchange markets across the globe. It is always being monitoring by governments, IMF, and other international agencies. When a currency counter is fluctuating wildly, central banks step in to buy the excessive supply to stop a currency from devaluing further. Or, when there’s a paucity of supply, agencies might step in with the surplus to bring down the value to a desired range.
References for Limited Flexibility Exchange Rate System
Academic Research on Limited Flexibility 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 Friedman’s 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.