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Floating Exchange Rate

DefnitionFloating exchange rate is a system in which a currency's value is determined solely by the

interplay of the market forces of demand and supply. It is actually determined by the soundness

of a country's basic economic position instead of by government intervention. However, all

central banks do try to defend these rates within a certain range by buying or selling their 

country's currency as the situation warrants.

In some instances, if a currency value moves in any one direction at a rapid and sustained rate,

central banks intervene by buying and selling its own currency reserves i.e. Federal Reserve in

the .!. does the same to stabili"e the local currency. However, central banks are reluctant to

intervene, unless absolutely necessary, in a floating exchange rate monetary system.

How does it work # floating exchange rate is determined by the private market through supply and demand. #

floating rate is often termed $self%correcting,$ as any differences in supply and demand will

automatically be corrected in the market. If demand for a currency is low, its value will decrease,

thus making imported goods more expensive and stimulating demand for local goods and

services. &his in turn will generate more obs, causing an auto%correction in the market. #

floating exchange rate is constantly changing.

 (o currency is wholly fixed or floating though. In a fixed exchange, market pressures can also

influence changes in the exchange rate. !ometimes, when a local currency reflects its true value

against its pegged currency may develop. It is a $black market$ which is more reflective of actual

supply and demand. # central bank will often then be forced to revalue or devalue the official

rate so that the rate is in line with the unofficial one. &his is done to halt the activity of the black 

market.

In a floating regime, the central bank may also intervene when it is necessary to ensure stability

and to avoid inflation. However, the instances of intervention are very few.

Advantages and Disadvantages o Floating Exchange

RatesFloating exchange rates have these main advantages)

• No need for international management of exchange rates ) Floating exchange rates

don*t re+uire an international manager such as the International onetary Fund to look 

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over current account imbalances. If a country has large current account deficits, its

currency depreciates under the floating system,

• No need for frequent central bank intervention) -entral banks fre+uently must

intervene in foreign exchange markets under the fixed exchange rate regime to protect the

gold parity, but such is not the case under the floating regime.

• No need for elaborate capital flow restrictions) It is difficult to keep the parity intact in

a fixed exchange rate regime while portfolio flows are moving in and out of the country.

In a floating exchange rate regime, the macroeconomic fundamentals of countries affect

the exchange rate in international markets, which, in turn, affect portfolio flows between

countries. &herefore, floating exchange rate regimes enhance market efficiency.

• Greater insulation from other countries’ economic problems) nder a fixed exchange

rate regime, countries export their macroeconomic problems to other countries. !uppose

that the inflation rate in the .!. is rising relative to that of the uro%"one.

Floating exchange rates also have disadvantages)

• Higher volatility) Floating exchange rates are highly volatile. acroeconomic

fundamentals can*t explain especially short%run volatility in floating exchange rates.

• Use of scarce resources to predict exchange rates) Higher volatility in exchange rates

increases the exchange rate risk that financial market participants face. &herefore, they

allocate substantial resources to predict the changes in the exchange rate, in an effort to

manage their exposure to exchange rate risk.

• Tendency to worsen existing problems) Floating exchange rates may aggravate existing

 problems in the economy. If the country is already experiencing economic problems such

as higher inflation or unemployment, floating exchange rates may make the situation

worse.

Dierence with Fixed Exchange RateFixed exchange rate) #n exchange rate regime where the value of a currency is fixed, or pegged,

to the value of another currency, or to the average value of a selection of currencies, or to the

value of some other commodity such as gold Floating exchange rate) #n exchange rate regime

where the value of a currency is allowed to be determined solely by the demand for, and the

supply of, the currency on the foreign exchange market

# fixed exchange rate system is one where the value of the exchange rate is fixed to another currency. &his means that the governments have to intervene in the foreign exchange market to

maintain the fixed rate. /here the exchange rate is floating the value will be determined by

market forces. #ll maor currencies in the world are determined by the supply and demand of the

currency. #s in any other market, the rate will change constantly to reflect how much of the

currency is being traded.