Floating exchange rates refer to the way in which a currency’s value is determined by the foreign exchange market, through the forces of supply and demand. This means that the value of a currency can fluctuate based on a variety of factors, and is not directly controlled by central banks. In contrast, a fixed exchange rate is when a currency’s value is pegged to that of another currency or basket of currencies, and central banks may intervene in the market to maintain a specific value for the currency. There are two types of flexible exchange rates: pure floating and managed floating. Pure floating regimes have no official intervention from central banks, while managed floating regimes involve some level of intervention. Prior to the 20th century, most governments used fixed exchange rate regimes, but after the collapse of the Bretton Woods system in 1973, many countries began to implement flexible exchange rate regimes.

A Floating exchange rate is a type of exchange rate regime in which a currency’s value is determined by the foreign exchange market through supply and demand forces. This means that the value of the currency can fluctuate based on various economic and political factors. Central banks may intervene in the market to stabilize the currency, but generally do not maintain strict control over its value. In contrast, a fixed exchange rate is one in which a currency’s value is pegged to the value of another currency or a basket of currencies.

To Float or Not to Float

A flexible exchange rate is a type of exchange rate regime in which a currency’s value is determined by the foreign exchange market through supply and demand forces. This means that the value of the currency can fluctuate based on various economic and political factors. Central banks may intervene in the market to stabilize the currency, but generally do not maintain strict control over its value. In contrast, a fixed exchange rate is one in which a currency’s value is pegged to the value of another currency or a basket of currencies.

Do Governments and Central Banks Interfere?

A floating exchange rate the value of the currency can fluctuate based on various economic and political factors, and is not directly controlled by central banks.

However, it doesn’t mean that countries don’t try to intervene or manipulate the value of their currency.

Governments and central banks may regularly attempt to influence the value of their currency in order to make it more favorable for international trade. This is known as a managed float. They can do this by buying or selling their own currency in the foreign exchange market in order to affect the supply and demand. For example, if a country wants to keep the value of its currency low, it may sell its own currency in the market, increasing the supply, which will decrease the price. Or if a country wants to keep the value of its currency high, it may buy its own currency in the market, decreasing the supply, which will increase the price.

How does a Floating Exchange Rate Works

In a floating exchange rate system, currency is bought and sold in the foreign exchange market, just like any other good or commodity. When a currency is in high demand, its value will increase, and when it is in low demand, its value will decrease.

For example, if many people want to buy the currency of Country A, the demand for that currency will increase, and so will its value. The increased value of the currency makes the country’s goods and services more expensive for foreigners, which can decrease exports and increase imports. Conversely, if people are selling the currency of Country A, the demand for that currency will decrease, and so will its value. This makes the country’s goods and services cheaper for foreigners, which can increase exports and decrease imports.

Governments and central banks may intervene in the market to stabilize the currency, but generally do not maintain strict control over its value. However, this doesn’t mean that countries don’t try to intervene or manipulate the value of their currency. Governments and central banks may regularly attempt to influence the value of their currency in order to make it more favorable for international trade, this is known as managed float. They can do this by buying or selling their own currency in the foreign exchange market in order to affect the supply and demand.

Advantage of Floating Exchange Rate

There are several potential advantage of a floating exchange rate system:

Automatic adjustment: A floating exchange rate allows for a country’s currency to automatically adjust to changes in economic conditions, such as changes in supply and demand for goods and services. This can help to promote stability and balance in the economy.

Flexibility: A floating exchange rate provides more flexibility in terms of monetary policy. Central banks have more freedom to set interest rates and implement other monetary policy measures to achieve their goals without being constrained by the need to maintain a fixed exchange rate.

Absorbing shocks: A floating exchange rate can help to insulate a country’s economy from negative external shocks, such as a decline in export demand. For example, if a country’s currency depreciates, it makes the country’s goods and services more affordable for foreigners, which can help to stimulate demand and offset the negative effects of the shock.

Reducing the risk of speculative attack: A floating exchange rate regime reduces the risk of speculative attacks on a country’s currency, since there is no fixed target for speculators to aim at.

Reflecting economic conditions: A floating exchange rate reflects the economic conditions of a country, making it a good indicator of the health of its economy.

It can help to promote more efficient use of resources: A floating exchange rate regime can help to ensure that resources are allocated to the most productive uses, by allowing market forces to determine the relative prices of goods and services in different countries.

Disadvantage of floating exchange rate

Volatility: A floating exchange rate can lead to increased volatility in the value of a currency, which can create uncertainty and instability in the economy. This can make it more difficult for businesses and consumers to plan for the future.

Balance of payments problems: A floating exchange rate can lead to persistent balance of payments problems, such as a persistent trade deficit or surplus. This can lead to imbalances in the economy and can have negative impacts on economic growth.

Inflation: A floating exchange rate can lead to increased inflation if the central bank does not adjust interest rates to keep pace with changes in the value of the currency.

Financial instability: A floating exchange rate can increase the risk of financial instability if large fluctuations in the value of the currency lead to defaults on loans or other financial difficulties.

Reduced competitiveness: A floating exchange rate can lead to reduced competitiveness in international trade if the value of the currency fluctuates too much.

It can lead to over-valuation or under-valuation of a currency: A floating exchange rate can lead to over-valuation or under-valuation of a currency, which can make it difficult for a country to maintain a competitive position in the global market.