What are the merits and demerits of a managed float system?

A managed float system offers flexibility and stability but can lead to manipulation and unpredictability.

The merits of a managed float system are numerous. Firstly, it provides a balance between the extremes of a fixed exchange rate and a completely floating exchange rate. This balance allows for a degree of stability in the exchange rate, which can be beneficial for international trade and investment. It reduces the risk of sudden and dramatic changes in the exchange rate, which can be disruptive to economic activity.

Secondly, a managed float system allows for some flexibility in monetary policy. The central bank has the ability to intervene in the foreign exchange market to influence the exchange rate. This can be useful in managing inflation and promoting economic growth. For example, if the central bank wants to stimulate the economy, it can lower the exchange rate to make exports cheaper and imports more expensive, thereby encouraging domestic production.

Thirdly, a managed float system can act as a buffer against speculative attacks on the currency. If speculators believe that the currency is overvalued, they may sell the currency in large quantities, causing a sharp depreciation. However, under a managed float system, the central bank can intervene to support the currency and prevent a sharp depreciation.

However, there are also demerits to a managed float system. One of the main criticisms is that it can lead to manipulation of the exchange rate. Governments may be tempted to devalue their currency to gain a competitive advantage in international trade. This can lead to 'currency wars', where countries compete to devalue their currencies, which can be destabilising for the global economy.

Another criticism is that a managed float system can be unpredictable. The exchange rate is influenced by a combination of market forces and central bank intervention, which can make it difficult to predict. This unpredictability can create uncertainty for businesses and investors, which can deter international trade and investment.

Lastly, managing the exchange rate can be costly. The central bank needs to hold large reserves of foreign currency to intervene in the foreign exchange market. These reserves can be expensive to maintain and can tie up resources that could be used elsewhere in the economy.

IB Economics Tutor Summary: A managed float system blends the stability of fixed exchange rates with the flexibility of floating ones, aiding trade and economic growth while offering protection against currency speculations. However, it may face challenges like potential manipulation for competitive trade advantages, unpredictability in exchange rates affecting businesses, and the high costs of maintaining foreign currency reserves for central banks.