Define what 'dirty float' and its varieties are and if they are likely to achieve theirs objectives.

Dirty Float

AIM

Define what ‘dirty float’ and its varieties are and if they are likely to achieve theirs objectives.

Background

Shortly after the Bretton Woods system collapsed in 1973, countries were free to use

expansionary monetary and fiscal policies to raise output and took advantage of the benefits of flexible rates. But in the 1980s, many countries including U.S. started to suffer from very large exchange rate swings and the dissatisfaction with flexible exchange rate regimes was generated. During this time, the major developed countries tried to manage the exchange rate to some degree by having central banks intervene in the foreign exchange markets. This was not a move to an actual fixed exchange rate regime, but is often referred to as a “managed float.”

Main Argument

Managed float (Dirty Float)

Market forces set rates unless excess volatility occurs, then, central bank determines rate by buying or selling currency. Managed float is not really a single system, but describes a continuum of systems. Under a managed float exchange rate regime, market forces are the principal factors influencing the exchange rate, but the government may intervene by buying or selling its own currency in the market. This is sometimes called a dirty float because under this exchange rate system, though it is technically a free float, the government does participate in the trading of currency.

There are three different varieties of ‘dirty float’ which are explained below.

Smoothing out the daily fluctuations

Government following this route attempt to preserve an orderly pattern of exchange rate changes. They tend to bring about longer-term currency appreciation or depreciation. One variant of this approach is the “crawling peg” system used in Hungary, Poland, and Brazil.

Evidence

Hungary’s experience in the crawling peg regime: benefits and costs

The pre-announced crawling peg regime was introduced in the spring of 1995 as one of the key elements of the Hungary Government’s stabilization package.

In 1995, an exchange rate buffer was provided by the decision of the NBH to extend the floatation band to ±2.25 percent (from ±1.25 percent). The whole rate was devalued by almost 20 percent in the first half of that year. Indeed, the depreciation of the rate on the foreign exchange markets was over 5 percentage points less than the official devaluation of the band-centre (See Table).

Since due to the massive (close to 30 per cent) unilateral devaluation in 1995 and the high interest rate premium, the market rates slid to the lower edge of the band in April and continued to stay there for quite a while. The monthly devaluation rate announced for 1996 was based on a projected inflation rate of about 20 per cent, however the sustainability of the regime, thanks to the intervention band of 4.5 per cent, permitted higher inflation without the exchange rate significantly damaging Hungary’s competitiveness.

Objectives achieved or not

Since spring 1996 inflation has been falling steadily, although more slowly than the government had expected in their annual forecasts. Following the historic low in 1994, the current-account deficit began to decrease in 1995, and is realistically expected to remain at a manageable level in the medium term. Economic growth also set off in 1996 after the decline of the transition years and the period of stagnation around the time of the stabilisation.

But, the narrow-band crawling peg regime had become ‘overdue’: for the past two years, it had not helped disinflation, ...