Economics: The Managed Float

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We've looked how supply and demand in the market for foreign exchange determines the exchange rate. We've also considered that the government might choose to play a role in the foreign exchange market of its country. When we think about the foreign exchange markets, they fall along a continuum. At one end of the continuum is a completely free market, in which the government stays out and the exchange rate is determined by the interaction of private supply and private demand. We might call this a floating exchange rate, one that moves completely with the private free market. At the other end is an exchange rate that is completely fixed by its central bank or government. A fixed exchange rate is announced by the government and the government buys and sells foreign currency in order to keep the price of its domestic currency exactly where it wants it. Now, no country in the world has a completely free market or a completely fixed exchange rate. The truth for every country is that they lie somewhere along a continuum between the two. Most countries have what's called a managed float. The exchange rate floats freely with movements in supply and demand, but the government will occasionally execute official foreign exchange transactions to try to move the exchange rate in a direction that it wants.
Now, why would the government want to do that? What's the advantage of a fixed exchange rate? Can a fixed exchange rate work? What consequences does it have and when does it breakdown? We're going to answer these question now in the context of consider the case of Mexico in 1993 and 1994, a famous example of a fixed exchange rate that seemed to work so well that it failed. But first, let's consider the most famous example of fixed exchange rates in the 20^th Century, the Bretton-Woods Agreement.
Following World War II, the most important economies in the world met in New Hampshire to negotiate a fixed exchange rate system, one in which all of the countries agreed to maintain their currency's price within a certain range for fixed rates, so that traders in all of the countries would be able to rely on fixed rates when they made long-term investments and committed to contracts. The Bretton-Woods system of fixed exchange rates worked relatively well, up until the early 1970's, when rapid increases in the price of oil sparked inflation and put countries in the difficult position of choosing whether to maintain fixed exchange rates or try to fight inflation at home. Finally, the system just broke down and, since the mid-1970's, most of the important economies of the world have had exchange rates that floated relatively freely. Smaller economies, like Mexico, however, sometimes find it advantageous to fix their exchange rate with that of a larger trader partner. Let's look at what happened in 1993, when Mexico endeavored to do that.
In January of 1993, Mexico announced that it would have a fixed exchange rate of 3 pesos to 1 US dollar. The intention of this fixed exchange rate policy was to allow Mexican importers of capital goods and services from the United States to rely on an exchange rate that made it profitable for them to do the investments and put in place the capital equipment that would allow them to take advantage of the North American Free Trade Agreement, which was shortly to kick in. Mexico was afraid that if the peso depreciated too much, capital investment would become unprofitable and its factories would be ill prepared to take advantage of newly arriving export opportunities to the United States. So the Bank of Mexico announced that it would do what it took to keep the peso at 3 pesos to the dollar.
Now, meanwhile, Mexican businesses see that these business opportunities are coming, so they want to buy a lot of capital goods and services. Mexican citizens see that the economy is improving and they want to spend some of this anticipated wealth on imported goods. In 1993, you start to see Mexican citizens shopping at Walmart, buying goods imported from the United States at reasonable prices with wealth that they're anticipating getting through the booming economy that NAFTA is creating. So what's happening in 1993 is that the demand for US dollars is increasing as the economy of Mexico grows and the businesses opportunities created by NAFTA are sparking investment. So, with the increased demand, there's going to be a tendency then for the equilibrium exchange rate to go up to something more like 3 pesos to the dollar and the quantity of dollars traded to increase. Now, this is at odds with the policy announced by the Bank of Mexico. The Bank of Mexico doesn't want this appreciation of the dollar, because they think it's bad for investment. Therefore, what the Bank of Mexico does is supply additional dollars to meet the demand for dollars, the increased demand, at the old price of 3 pesos to the dollar. The increase in supply can be called an official foreign exchange intervention. Look what's happening: the consumers and businesses of Mexico want more dollars and they'd just as soon get them at the old price. But, at the old price, there would be excess demand, which would push up the price of dollars. So the government, rather than letting the price rise, increases the supply of dollars so that we get equilibrium back at the original price of 3 pesos to a dollar. This is how a fixed exchange rate works.
Now, what's going to happen here is that the government is eventually going to run out of dollars if it keeps supplying dollars every period to people who are hungry for dollars at 3 pesos to the dollar. So what the Bank of Mexico declared into 1993 was that they would change the peg; that is, the fixed exchange rate changed from 3 pesos to the dollar to 3.3 and, eventually, up to 3.5 pesos to the dollar. So what we got here was a managed float. Notice the price of the peso changed, but it changed according to government decision. The government allowed the peso-dollar price to adjust. This is called a managed float. So now there's no need for further official action, because now that the target has been redefined, we're sitting right where the market wants us.
Now, things are going along fine, until there's a disaster. The candidate Collosio for Presidency of Mexico, he represents the PRI, the leading party in Mexico, is assassinated in Tiujana. And, all of a sudden, Mexicans, as well as people in the United States, fear that Mexico is about to enter a period of political instability that's going to be bad for investment and bad for the overall health of Mexico's economy. So now we get two big adjustments; first, we get people in the US now less willing to invest money in Mexico, and therefore the supply curve of US dollars shifts in. At the same time, Mexicans decide that they want to put more of their money in safe havens, and therefore they demand more dollars, so that they can put some in savings accounts in the United States, just in case there's a disaster. Well, notice now that at the target of 3.5 pesos to the dollar, we've got this huge excess demand for dollars, as Mexicans want a lot and US nationals are afraid to supply them, because of the political instability. And the only way to eliminate this excess demand would be for there to be a huge depreciation of the peso, maybe up to something more like 6 pesos to the dollar. Well, that's totally at odds with the government's target. And therefore, what happens is the Bank of Mexico makes up for the excess demand by shifting the official supply curve way, way out here, so that, along the new demand curve, we get an intersection at the price that they want, 3.5 pesos to the dollar. Now eventually, they let that managed float take us up to something more like 4 pesos to the dollar, but they're still holding on there to the notion that they can set a price that the market doesn't want. The market wants 6 pesos to the dollar, but the government wants 3.5. They keep pumping dollars into the market, keep buying up those orphaned pesos, filling the coffers of the Bank of Mexico with pesos, coughing up dollars, until finally, in November of 1994, it becomes apparent that they're about to run out of dollars. They're down to $4 billion left. They started with $25 billion in January of 1993. In November of 1994, they're practically out. So what do they do? They simply declare there's going to be no more official support for the peso. And whenever they take off the official support, guess where we go? Bam! Exactly where the market wants us, 6 pesos to the dollar. And it happens precipitously, which means that if you owned a mutual fund in Mexico, it lost 40% of its value in a couple of days, a big, big change because of depreciation of the peso.
Now, notice this is a situation in which the success of Mexico created a failure. Mexicans, anticipating new wealth, wanted to spend on imports, wanted to spend on capital goods, increase their demand for dollars and, when they did, they pushed the peso to a point to where the government could not support an announced exchange rate target. And Mexico then went through a period of great economic turmoil over this. Inflation, high interest rates; taking advantage of NAFTA was set back. The same thing happened in Thailand in 1997. The same thing happened in Europe, in Britain, in 1992. Trying to defend a fixed exchange rate against where the market is trying to take it ultimately becomes unsupportable. And then currency speculators go at you. They see that you're exchange rate is about to shoot up to 6 pesos to the dollar, so they start selling it early, which just makes it harder, because it causes pressure for the exchange rate to go ahead and change.
So there you have it. A fixed exchange rate, a floating exchange rate and, in between, we've got things like managed floats and adjusting pegs and the government is playing some role. Now, ultimately, it's impossible for the government to totally oppose the market. Nobody has enough foreign exchange reserves to keep the exchange rate from going where the market wants it. $1.2 trillion worth of foreign currency are traded every business day around the world and no government has that much in foreign exchange reserves. No government could oppose the movement of its exchange rate, if that's where the market wanted to take it. However, in the meantime, governments can nudge this way, that way, try to suggest what they want to do, but they can't fight the market indefinitely, as Mexico learned, as Thailand learned. But an effort to maintain a fixed exchange rate can do some good, if it's for the short-run and it's not too far away from the actual market equilibrium.
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