International Financial Management

• Free float
• Managed float
• Target zone arrangements
• Fixed rate system
• Hybrid system (current)

In a free float, exchange rates are determined by the interaction of currency supplies and demands.

Under a system of managed floating, governments intervene actively in the foreign exchange market to smooth out exchange rate fluctuations in order to reduce the economic uncertainty associated with a free float.

Under a target-zone arrangement, countries adjust their national economic policies to maintain their exchange rates within a specific margin around agreed-upon, fixed central exchange rates.

Under a fixed-rate system, such as the Bretton Woods system, governments are committed to maintaining target exchange rates. Each central bank actively buys or sells its currency in the foreign exchange market whenever its exchange rate threatens to deviate from its stated par value by more than an agreed-on percentage.

Currently, the international monetary system is a hybrid system, with major currencies floating on a managed basis, some currencies freely floating, and other currencies moving in and out of various types of pegged exchange rate relationships.

Benefits of a Floating Rate System.

• 1973, proponents said :
  • reduce economic volatility and facilitate free trade.
  • floating exchange rates would offset international differences in inflation rates so that trade, wages, employment, and output would not have to adjust.
  • High-inflation countries would see their currencies depreciate, allowing their firms to stay competitive without having to cut wages or employment.
    • At the same time, currency appreciation would not place firms in low-inflation countries at a competitive disadvantage.
  • Real exchange rates would stabilize, even if permitted to float in principle, because the underlying conditions affecting trade and the relative productivity of capital would change only gradually
  • and if countries would coordinate their monetary policies to achieve a convergence of inflation rates, then nominal exchange rates would also stabilize.
• Milton Friedman
  • with a floating exchange rate, there never has been a foreign exchange crisis.
    • The floating rate absorbs the pressures that would otherwise build up in countries that try to peg the exchange rate while simultaneously pursuing an independent monetary policy. 
  • A floating rate system can also act as a shock absorber to cushion real economic shocks that change the equilibrium exchange rate.

Costs of a Floating Rate System.

• excessive volatility
  • dollar's ups and downs have had little to do with actual inflation and a lot to do with expectations of future government policies and economic conditions.
  • Real exchange rate volatility has increased, not decreased, since floating began.
  • This instability reflects, in part, nonmonetary (or real) shocks to the world economy, such as changing oil prices and shifting competitiveness among countries, but these real shocks were not obviously greater during the 1980s than they were in earlier periods.
    • Instead, uncertainty over future government policies has increased.