Definition of Floating Rate System

In a floating-rate system, it is the market forces that determine the exchange rate between two currencies. The advocates of the floating-rate system put forth two major arguments. One is that the exchange rate varies automatically according to the changes in the macro-economic variables.

As a result, there does not appear any gap between the real exchange rate and the nominal exchange rate. The country does not need any adjustment that is often required in a fixed-rate regime and so it does not have to bear the cost of adjustment (Friedman, 1953). The other is that this system possesses insulation properties meaning that the currency remains isolated of the shocks emanating from other countries. It also means that the government can adopt an independent economic policy without impinging upon the external sector performance (Friedman, 1953).

However, the empirical studies do not necessarily confirm these views. MacDonald (1988) finds that the exchange rates among the countries on floating rate system during 1973-85 were much more volatile than warranted by changes in fundamental monetary variables. Dunn (1983) finds absence of insulation properties. During early 1980s, when the USA was practicing tight monetary policy through raising interest rates, the European countries raised interest rates so as to prevent large outflow of capital to the USA. Again, since the nominal exchange rate tendered to adjust more rapidly than the market price of goods, nominal exchange rate turbulence was closely related to real exchange rate turbulence (Frenkel and Mussa, 1980). Cushman (1983) feels that uncertainty in real exchange rate did affect trade among several industrialized countries. Dunn (1983) gives an example of Canadian firms borrowing long-term funds from the USA that faced heavy losses due to 14 percent real depreciation of Canadian dollar during 1976-79. He also finds that large appreciation in the real value of pound in late 1970s had led to insolvency of many UK firms as their products turned uncompetitive in world market.

Besides, developing countries in particular do not find floating rates suitable for them. Since their economy is not diversified and since their export is subject to frequent changes in demand and supply, they face frequent changes in exchange rates. This is more especially when foreign demand for the products is price-inelastic. When the value of their currency depreciates, export earnings usually sag in view of inelastic demand abroad. Again, greater flexibility in exchange rates between a developed and a developing country generates greater exchange risk in the latter. It is because of low economic profile of the developing countries and also because they have limited access to forward market and to other risk-reducing mechanisms.

Floating rate system may be independent or managed. Theoretically speaking, the system of managed floating involves intervention by the monetary authorities of the country for the purpose of exchange rate stabilization. The process of intervention interferes with market forces and so it is known as “dirty” floating as against independent floating which is known as “clean” floating. However, in practice, intervention is global phenomenon. Keeping this fact in mind, the IMF is of the view that while the purpose of intervention in case of independent floating system is to moderate the rate of change, and to prevent undue fluctuation, in exchange rate; the purpose in managed floating system is to establish a level for the exchange rate.

Intervention is direct as well indirect. When the monetary authorities stabilize exchange rate through changing interest rates, it is indirect intervention. On the other hand, in case of direct intervention, the monetary authorities purchase and sell foreign currency in the domestic market. When they sell foreign currency, its supply increases. The domestic currency appreciates against the foreign currency. When they purchase foreign currency, its demand increases.

The domestic currency tends to depreciate vis-à-vis the foreign currency. The IMF permits such intervention. If intervention is adopted for preventing long-term changes in exchange rate away from equilibrium, it is known as “learning-against-the-wind” intervention. Intervention helps move up or move down the value of domestic currency also through the expectations channel. When the monetary authorities begin supporting the foreign currency, speculators begin buying it forward in the expectation that it will appreciate. Its demand rises and in turn its value appreciates vis-à-vis domestic currency.

Intervention may be stabilizing or destabilizing. Stabilizing intervention helps move the exchange rate towards equilibrium despite intervention. The former causes gains of foreign exchange, while the latter causes loss of foreign exchange. Suppose rupee depreciates from 33 a dollar to 36 a dollar. The Reserve Bank sell US $ 1000 and rupee improves to 33.

The RBI will be able to replenish the lost reserves through buying dollar at ` 33/US $. The gain will be US $ (36000/33-1000) or US $ 91. But after intervention, if rupee falls to 40 a dollar, the loss will be US $ (36000/40-1000) or US $ 100. The monetary authorities do not normally go for destabilizing intervention, but it is very difficult to know in advance whether intervention would be really destabilizing. The empirical studies show both the stabilizing and destabilizing intervention. Longworth’s study (1980 finds stabilizing intervention in case of Canadian dollar, while Taylor (1982) finds destabilizing intervention in case of some European countries and Japan during 1970s.

Again, intervention may be sterilized or non-sterilized, when the monetary authorities purchase foreign currency through created money, the money supply in the country increases. It leads to inflation. This is example of non-sterilized intervention, but if simultaneously, securities are sold in the market to mop up the excess supply of money, intervention does not lead to inflation. It takes the form of sterilized intervention. The study of Obstfeld (1983) reveals that non-sterilized intervention is common, for sterilized intervention is not very effective in view of the fact that it does not change very evidently the ratio between the supply of domestic currency and that of the foreign currency. However, on the whole, Loopesko (1984) confirms the effect of the intervention on the exchange rate stabilization. Last but least, there has also been a case of co-ordinated intervention. As per the Plaza Agreement of 1985, G-5 nations had intervened in the foreign exchange market in order to bring US dollar in consistence with the prevailing economic indicators.