Exchange-rate regimes: fixed, floating and managed float

Detail

1. Basic terms

• Exchange rate: the price of one currency in terms of another. In India it is written as ₹ per $ (e.g. ₹50/$).
• If ₹/$ rises (₹50 → ₹70), each dollar costs more rupees. The rupee is weaker.

• If ₹/$ falls (₹70 → ₹50), the rupee is stronger.

• Exchange-rate regime: the rules a country follows to decide its exchange rate. Either the government fixes it, the market sets it, or the result is a mix of both.

• Forex reserves: foreign currency, gold and similar assets held by the central bank (RBI). They are the "ammunition" the RBI uses to buy or sell dollars.
• Official reserve transactions: the RBI's purchases and sales of forex. They are recorded in the BoP and make it balance.

2. Fixed exchange rate

Definition: the government announces a rate. The central bank buys or sells forex at that rate, so the market price cannot move away from it.

Case A: rate set ABOVE the market rate (Class 12, Fig. 6.3)

• The market rate, where demand for $ equals supply of $, is ₹50/$. The government fixes e₁ = ₹70/$.
• At ₹70:
• exporters get more rupees for each dollar, so exports rise and supply of $ rises;

• imports cost more, so demand for $ falls.

• Supply of $ is greater than demand. This excess is the gap AB in Fig. 6.3.

• To stop the rate falling back to ₹50, the RBI buys the extra dollars. So reserves pile up for as long as it keeps doing this.
• Purpose: a cheap rupee that promotes exports.
• Worked example: at ₹70, supply of $ = $120 bn and demand = $90 bn. The RBI must buy $30 bn (the gap AB). To do this it pays ₹70 × 30 bn = ₹2,100 bn (₹2.1 lakh crore) in new rupees. That extra money adds to domestic money supply (a side effect).

Case B: rate set BELOW the market rate (e₂)

• The rupee is kept artificially strong, so imports are cheap and demand for $ is greater than supply.
• The RBI must sell dollars from its reserves to fill the gap.
• Reserves are limited. When they run out, people who cannot get dollars at the official rate pay more for them illegally. This creates a black market for foreign exchange: an illegal market where the dollar sells above the official rate.

History of fixed systems (Class 12, Q19)

• Gold standard: each currency had a fixed value in gold, so rates between currencies were fixed.
• Bretton Woods system (1944 to early 1970s): a fixed but adjustable system.
• The US dollar was tied to gold at $35 per ounce.
• Other currencies were tied to the dollar.
• Countries could change their peg only when there was a "fundamental" imbalance.

• It collapsed in the early 1970s. The US stopped converting dollars into gold (1971) after repeated speculative attacks.

• After that, the world drifted into managed floating without any formal agreement.

3. Devaluation vs depreciation (NCERT Q7)

Devaluation / revaluation	Depreciation / appreciation
Government decision, fixed regime	Market forces, flexible regime
Devaluation: the government raises ₹/$ (e.g. ₹50 → ₹60), so the rupee becomes cheaper	Depreciation: the market pushes ₹/$ up
Revaluation: the government lowers ₹/$, so the rupee becomes dearer	Appreciation: the market pushes ₹/$ down

• Worked example (% devaluation): ₹50 → ₹60 per $. Change in the ₹/$ rate = (60 − 50)/50 × 100 = 20%.
• Measured as the rupee's value in dollars: 1/50 = $0.020 falls to 1/60 = $0.0167, a fall of about 16.7%.

• Exam trap: the two percentages differ. Check which one the question asks for.

• India, July 1991: in the external payments crisis, the rupee was devalued in two stages (1 and 3 July 1991). The total devaluation was about 18% in USD terms [3].

4. Credibility and speculative attacks

• A fixed rate works only if people believe the government can defend it, i.e. that it has enough reserves.
• Speculative attack: when reserves look too small, speculators expect a devaluation.
• They sell the domestic currency and buy forex.
• The central bank loses even more reserves defending the peg.

• It is finally forced to devalue or float. The fear makes itself come true.

• Examples:

• Repeated attacks on currencies before Bretton Woods collapsed.
• Black Wednesday (16 Sept 1992): the UK pound was forced out of the ERM (European Exchange Rate Mechanism, a system that kept European currencies within set bands).
• Thai baht (2 July 1997): Thailand floated the baht, which set off the Asian financial crisis.

5. India's path: from fixed to market-based (1991-1994)

• 1991 BoP crisis (Class 11): India's forex reserves fell so low that they could pay for only about two weeks of imports. This forced devaluation and the LPG reforms.
• Steps in the move to a market-based rate:
• July 1991: two-step devaluation, about 18% in total [3].
• March 1992: LERMS (Liberalised Exchange Rate Management System), a dual exchange rate system. Part of forex earnings was converted at the official rate and the rest at the market rate. It was the first step towards a market-set rate [2][3].
• 1 March 1993: LERMS replaced by a unified, single, market-determined exchange rate, based on demand for and supply of forex [2][3].
• August 1994: the rupee became convertible on the current account (for trade and similar payments), and India accepted Article VIII of the IMF's Articles of Agreement [3].

• 1999: FEMA replaced FERA, 1973. The earlier law punished forex violations as crimes; the new one "manages" forex [3].

• The capital account is still only partly open. This is the reason for India's "middle path" (see §9).

6. Floating exchange rate

Definition: the rate is set purely by the market's demand for and supply of forex. The central bank does not intervene, so official reserve transactions = 0.

Merits (Class 12)

• Automatic BoP adjustment:
• a deficit means more demand for $, so the rupee depreciates;
• exports become cheaper and imports dearer;

• the deficit shrinks.

• Less need for large reserves, because the rate does the adjusting.

• Independent monetary policy: the RBI can set interest rates for domestic goals (inflation, growth) and does not have to defend a rate.

Demerits

• Volatility (big up-and-down swings) creates uncertainty for traders and investors.
• Sharp depreciation can make imports like oil more expensive and raise inflation.

7. Managed floating ("dirty floating")

Definition: a mix of fixed and floating. The market mainly sets the rate, but the central bank buys and sells currencies to moderate movements.

• Official reserve transactions ≠ 0 (NCERT Q8: yes, the central bank intervenes).
• The world moved to this system without any formal international agreement.
• Forex intervention: the central bank buys or sells forex to influence the rate or reduce volatility.
• Rupee falling too fast: the RBI sells $.
• Rupee rising too fast: the RBI buys $, and reserves grow.

How the RBI does it

• Stated policy: curb excess volatility, without targeting any fixed level of the rupee [5].
• The RBI's aim is to keep orderly conditions in the forex market. It watches domestic and global financial markets and buys or sells foreign currency when needed [2].
• Tools:
• Spot operations: buying or selling $ for immediate delivery.
• Forward operations: contracts to buy or sell $ at a future date. Selling $ forward cools forward premia.
• Buy/sell swaps: buying $ now and agreeing to sell them later, or the reverse. This manages rupee liquidity and the rate together.

The buffer

• India's forex reserves were US$ 698.19 bn (week ended 25 July 2025), of which foreign currency assets were US$ 588.93 bn and gold US$ 85.70 bn [4].
• Compare this with a two-weeks-of-imports cover in 1991.

8. Regime spectrum (hardest peg to freest float)

Regime	Meaning	Example
Dollarisation	No national currency; a foreign currency (usually the US $) is used	Ecuador, Panama
Currency board	Domestic currency is issued only against 100% foreign-reserve backing at a fixed rate	Hong Kong since 1983, ~HK$7.8/$
Conventional peg	Fixed to one currency or a basket, with small bands; can be adjusted	Gulf states' pegs to the $
Crawling peg	Peg adjusted periodically in small steps, often in line with inflation differences	—
Managed float	Market-led, with intervention	India (de jure)
Free float	Market-set, very rare intervention	USA, Japan

• Crawling peg, worked example: the peg is ₹80/$. Indian inflation is 5% and US inflation is 2%, a gap of 3%. The peg is moved about 3% a year, i.e. roughly ₹80 → ₹82.4, often in monthly steps of about 0.25%.
• Crawl-like arrangement (IMF term): the rate stays within a narrow band around a trend for at least 6 months, even if the country does not officially declare it [5].

9. India's IMF classification: de jure vs de facto

• De jure: what the country officially says. De facto: what the IMF sees in the data.
• India's de facto classification moved:
• from "floating",
• to "stabilised arrangement" (Dec 2022-Oct 2023): the rate stayed within a very narrow band,

• to "crawl-like arrangement".

• The IMF 2025 Article IV report confirms: India's de jure regime is floating, its de facto regime is a crawl-like arrangement, and the RBI's stated intervention aim is to curb excessive volatility [5].

10. Impossible trinity (Mundell-Fleming "trilemma")

Definition: a country cannot have all three of the following at once. It must give up one:

1. a fixed exchange rate;
2. free capital movement (money flows freely in and out);
3. independent monetary policy (setting its own interest rates).

Choice	Gives up	Example
Fixed rate + free capital	Independent monetary policy	Hong Kong currency board
Free capital + independent policy	Fixed rate	USA (free float)
Fixed rate + independent policy	Free capital (uses capital controls)	Bretton Woods era; pre-1991 India

• Why it cannot work, step by step:
• The RBI cuts rates while the rate is fixed and capital is free.
• Investors move money out to earn higher returns abroad.
• Demand for $ rises and pressure builds on the peg.

• The RBI must sell reserves or raise rates again. So its independence is lost.

• India's middle path: partial capital-account openness plus a managed float, with large reserves as the cushion.

11. Currency wars and manipulation

• Competitive devaluation: countries deliberately weaken their currencies so their exports get cheaper, at trade partners' cost. Partners then retaliate, and in the end nobody gains.
• 1930s "beggar-thy-neighbour" policies during the Great Depression.

• 2010 "currency wars": after the 2008 crisis, easy money in rich countries pushed capital into emerging markets.

• Currency manipulation: deliberately holding a currency down to gain a trade advantage.

• The US Treasury FX Report uses 3 criteria:
  1. a significant bilateral trade surplus with the US;
  2. a material current-account surplus;
  3. persistent, one-sided intervention (mostly buying $).
• Economies that meet some of the criteria go on a monitoring list. India has been on it at times (verify current status).

12. J-curve and Marshall-Lerner condition

• J-curve effect:
• Just after a depreciation, the trade balance first worsens. Import contracts are already signed, so the same quantity now costs more rupees.
• Over time, export and import volumes adjust, and the balance improves.

• Plotted against time, the line dips and then rises, like the letter "J".

• Marshall-Lerner condition: a depreciation improves the trade balance only if |e_X| + |e_M| > 1 where e_X = price elasticity of demand for exports and e_M = price elasticity of demand for imports. (Elasticity measures how strongly quantity reacts to a price change.)

• Worked example: the rupee depreciates 10%.

• If e_X = 0.6 and e_M = 0.7, the sum is 1.3 > 1. Volumes react enough, and the trade balance improves.

• If e_X = 0.2 and e_M = 0.3, the sum is 0.5 < 1. The higher import bill outweighs the volume gains, and the trade balance worsens.

• This is Class 12's elasticity caveat: a depreciation does not always fix a deficit.

Prelims Hooks

• Devaluation is a government act under a fixed regime. Depreciation is a market outcome under a floating regime.
• Under a pure float, official reserve transactions = 0. Under a managed float they are ≠ 0.
• Rate fixed above the market rate (weak rupee): the RBI buys $, and reserves rise. Rate fixed below it: reserves fall, which can lead to a black market.
• LERMS (dual rate) started in March 1992. A unified market-determined rate came on 1 March 1993. Current-account convertibility / IMF Article VIII came in August 1994 [2][3].
• The July 1991 devaluation was in two stages, ~18% in total in USD terms [3].
• IMF 2025: India is de jure floating and de facto crawl-like [5].
• Currency board: 100% reserve backing. Hong Kong has had one since 1983 (~HK$7.8/$).
• Impossible trinity: fixed rate + free capital flows + independent monetary policy. Only two of the three are possible.
• Marshall-Lerner: sum of export and import demand elasticities > 1.
• Black Wednesday (16 Sept 1992) was the UK/ERM crisis. 2 July 1997 was the Thai baht float that started the Asian crisis.

Mains Points

• Why India prefers a managed float:
• Wild swings in the rupee hurt exporters, importers and firms with foreign-currency debt, and they feed inflation through costlier oil.
• Large reserves (US$ 698 bn, July 2025 [4]) let the RBI smooth these swings without fixing a level.

• Critique: the IMF's reclassification to "stabilised" and then "crawl-like" [5] suggests heavy intervention. That can weaken the rupee's role as a shock absorber and invite scrutiny such as the US monitoring list.

• Trilemma trade-off:

• Full capital account convertibility would expose India to sudden capital outflows (the 1997 Asian crisis is the warning).

• So India keeps it gradual, retaining monetary independence and some control over the exchange rate.

• Lessons of 1991:

• A near-fixed rate with low reserves and a rising current account deficit is open to credibility loss and speculative attack.

• The reform path (devaluation → LERMS → unified rate → current-account convertibility) shows sequencing: move in steps, not overnight [3].

• Depreciation is not a cure-all:

• J-curve lags and low elasticities (Marshall-Lerner) limit export gains.
• India's import basket (oil, electronics, gold) is price-inelastic.
• So structural competitiveness (logistics, productivity, PLI) matters more than a weak rupee. Competitive devaluation also risks retaliation.