A variable exchange rate is an exchange rate system in which the price of a country`s currency is determined by the foreign exchange market, based on supply and demandOffer and demandThe laws of supply and demand are microeconomic concepts that state that in efficient markets, the quantity of a good supplied and the quantity of other currencies are present. A variable exchange rate, unlike a fixed exchange rate, is not limited by trade restrictions or government controls. Variable exchange rates are sensitive to fluctuations and are inherently highly volatile. The value of one currency against another currency can only deteriorate on a trading day. Moreover, the short-term volatility of a variable exchange rate cannot be explained by macroeconomic fundamentals. When a country suffers from economic problems such as unemployment or high inflation, exchange rate fluctuations can exacerbate existing problems. For example, the devaluation of a country`s currency, which already suffers from high inflation, will lead to a continuous rise in inflation due to a growing demand for goods. In addition, costly imports can worsen the country`s current account. The name of the International Monetary Fund for an exchange rate system with managed floating is the limited flexibility exchange rate system. A flexible exchange rate system is a monetary system that determines the exchange rate by supply and demand. Any recognized state that creates a currency must decide what kind of exchange rate agreement to maintain.
There are several heterogeneous approaches between permanently fixed and completely flexible. They have different effects on the extent to which national authorities participate in foreign exchange markets. An exchange rate system with limited flexibility is an exchange rate control policy in which an exchange rate, which is generally allowed to adjust to the equilibrium level, through the interaction of supply and demand in the foreign exchange market, but with occasional state intervention. Most countries in the world, also known as managed floats or dirty floats, currently use a managed flexible exchange rate policy. With this alternative, an exchange rate can rise and fall freely, but it is subject to state control if it rises or falls too low. With Managed Float, the government enters the foreign exchange market and buys or sells any currency needed to keep the exchange rate within the desired limits. This is one of three basic exchange rate policies used by national governments. The other two directives are the flexible exchange rate and the fixed exchange rate.
A managed variable exchange rate policy is similar to that of a mother who allows her young son to play outside, but does not allow him to leave the court. Free play in the backyard is the flexible part and not leaving the backyard is the managed/fixed part. Assumptions of perfect asset substitutability and perfect capital mobility will continue to lead to i=iF. Again, the BP curve is a horizontal line at i=iF. Only now does the balance of payments mean an official balance of accounts of zero. Changes in the exchange rate lead to changes in the IS curve. With fixed prices of domestic and foreign commodities, the devaluation of the national currency will make domestic products relatively cheaper and boost domestic exports. Since net exports are part of total spending, the EI curve will shift to the right. An appreciation of the national currency will reduce domestic net exports and lead to a shift in the IS curve to the left. Central banks can also intervene indirectly in foreign exchange markets by raising or lowering interest rates to influence the flow of money from investors into the country. Because attempts to control prices within narrow ranges have failed in the past, many countries choose to keep their currency free and then use economic instruments to steer it in one direction or another when it goes too far for its convenience. Extreme short-term movements can lead to central bank intervention, even in a variable interest rate environment.
For this reason, while most of the world`s major currencies are considered fluctuating, central banks and governments can intervene when a country`s currency becomes too high or too low. Milton Friedman was a great defender of floating exchange rates. In his article “The Case for Flexible Exchange Rates,” 1953, he pointed out how flexible exchange rates would improve the global economy through monetary independence. Economists Robert Mundell and Marcus Fleming, as shown in the IS-LM-BoP model derived from their work, have also pointed out how harmful fixed exchange rates can be. .