Flexible Exchange Rate Regime

In contrast to the fixed exchange rate regime, the flexible exchange rate system encompasses various forms of exchange rate regimes that allow the exchange rate of two nations to be determined by the demand and supply of the currencies in the foreign-exchange market. The term floating exchange rate is also used to describe the general form of the flexible exchange rate in the system. In principle, the flexible exchange rate system is driven by a free market force while allowing some variations of central bank intervention. Major forms of exchange rate regimes under the flexible exchange rate system include freely floating (or clean floating) and managed floating (or dirty floating). In some cases, adjustable peg and crawling peg are also considered part of the flexible exchange rate system.

In the early 1970s, countries with major currencies, such as the United States, began to adopt a flexible rate system after the collapse of the Bretton Woods system, under which a fixed or pegged exchange rate regime prevailed. Though the majority of the developing nations still remained on the fixed exchange rate at the time, many had shifted to more flexible exchange rate systems such as the adjustable peg, crawling peg, and managed floating exchange rate systems.

What caused the movement from a fixed to a more flexible exchange rate system in this 20-year period for the emerging markets, though via a gradual process, were (1) sharp changes in value in major currencies that these nations tied their currencies to, (2) slower growth of more developed nations that launched opportunity seeking in the developing nations, (3) steep rise in the interest rate worldwide that encouraged a more flexible exchange rate system, (4) debt crisis as a result of overexpansion or huge capital inflow that put pressure on local currencies, and (5) inflation problems that called for changes in monetary policy that are more suited for a flexible exchange rate regime. In short, during these volatile times, a more flexible exchange rate regime was demanded for countries under fixed exchange rate regimes to adapt quickly and to be able to survive in the international trade and investment market. In other words, as the financial market globalized and the developing economies were more closely integrated with those of the more developed, the international exchange rate system had moved toward forms that allow nations to work more cooperatively and efficiently.

Though quite a few developing countries shifted to a more flexible exchange rate system after the mid-1990s, many still adopted the system with various degrees of control through central bank intervention or managed floating. This trend was due to the nations' smaller economies and relatively thin financial markets that were intolerant of extreme volatilities. In addition, many of these nations depend heavily on their exports or imports, and any big swings in their foreign exchange rates could cause serious imbalances in their balance of payments (e.g., a sudden depreciation in a nation's currency accompanied by a large import would cause a huge increase in its deficit in balance of payments).

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