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What’s it? A pure floating exchange rate, or free-floating exchange rate, is a system of exchange rates in which the value of a domestic currency against a foreign currency moves according to a market mechanism. The market mechanism is the supply-demand in the foreign exchange market (forex market). Under this system, supply and demand determine the movements of the exchange rates.
Pure floating exchange rates contrast with fixed exchange rates. Under the latter system, the exchange rate is pegged at a certain level and does not move. To maintain the target level, the government actively intervenes in the market.
How the pure floating exchange rate works
In a pure floating exchange rate, governments do not intervene. The market mechanism determines the domestic currency exchange rates. Changes in demand and supply ultimately move the exchange rate toward equilibrium. When domestic currency demand is higher than supply, the domestic currency’s exchange rate will appreciate. Appreciation tends to make the trade balance negative because export demand falls and import demand rises. That will eventually lead to a depreciation in the exchange rate.
Meanwhile, the domestic currency will depreciate when supply is higher than demand. Depreciation increases exports and reduces imports, increasing the domestic currency’s purchasing power against foreign currencies (appreciation).
Some countries might adopt managed floating exchange rates. These rates move freely within a specific range, following the forex market’s supply and demand.
However, if the movement becomes unfavorable, the government intervenes in the market. Such intervention avoids sharp fluctuations in the exchange rate and supports economic stability.
Factors affecting the pure floating exchange rate
Several factors influence exchange rate movements, including inflation rates, interest rates, trade balance, foreign exchange reserves, and economic growth. They affect exchange rates through their impact on the trade balance and capital flows.
The trade balance and capital flows are two sources of supply and demand in the forex market. In addition to these two, supply and demand are also influenced by speculative activity.
Trade balance
Exports increase the demand for domestic currency. Buyers in partner countries need domestic currency to pay for domestic goods purchased. As a result, the domestic currency tends to appreciate as exports increase.
Conversely, an increase in imports leads to depreciation. Domestic consumers demand foreign currency to pay for imported goods. They then sell the domestic currency and exchange it for foreign currency. Such a situation weakens the domestic currency’s price (purchasing power) against the trading partner’s currency (depreciation).
Overall, the trade deficit depreciates because imports are more significant than exports. Conversely, a trade surplus increases the exchange rate.
The market mechanism will eventually move the exchange rate toward its new equilibrium when there is appreciation or depreciation.
How does it work?
Say the domestic currency depreciates because of the trade deficit. Depreciation makes domestic goods cheaper for foreigners, which increases demand. As a result, exports increase.
Conversely, depreciation increases the price of foreign goods. This reduces imports because domestic consumers tend to reduce demand for foreign goods. As a result, the trade deficit decreases, and the domestic currency appreciates.
Please remember. In this case, we assume the constant elasticity of demand for exported and imported goods. If demand elasticity is at work, the effects of depreciation on exports and imports would not be as easy as the above.
The demand for foreign goods is less elastic than the demand for domestic goods. Domestic consumers are less responsive to price changes than overseas consumers. Depreciation makes the price of foreign goods more expensive. Because domestic consumers are less responsive, the decline in imports will be relatively small.
Conversely, because foreign consumers are more responsive to price changes, depreciation will considerably increase export demand, more significantly than a decrease in imports. Therefore, the trade balance might turn into a surplus from the previous deficit.
Capital flow
The demand and supply of currency also work through the capital flow. Capital inflows increase demand for the domestic currency and lead to appreciation. Conversely, capital outflow causes depreciation because people sell the domestic currency and convert it into foreign currency.
One critical factor affecting capital flows is the interest spread between domestic and international markets. Suppose the domestic interest rate is too low relative to the international interest rate. In that case, capital flows out of the domestic market. Investors will look for higher returns abroad. Capital outflow depreciates the domestic currency.
Conversely, if domestic interest rates are relatively high compared to international interest rates, capital inflows. Foreign investors see the domestic market offering more attractive returns, and capital inflows increase domestic currency demand. As a result, the domestic currency tends to appreciate.
Advantages of pure floating exchange rate system
The two advantages of adopting a pure floating exchange rate are:
- Macroeconomic policy flexibility
- Unrequire large foreign reserves
Macroeconomic policy flexibility
Pure floating exchange rates enable countries to isolate their macroeconomic policies. By allowing the exchange rate to move freely, the central bank’s intervention is unnecessary. Hence, the central bank has the independence to implement its policies.
That contrasts with a fixed exchange rate. Central banks must actively intervene in the forex market. Suppose the exchange rate moves due to changes in economic policy abroad. In that case, it requires the central bank to take similar action. Long story short, under a fixed exchange rate, economic policies abroad could dictate domestic economic policies.
Assume that the reference to the rupiah fixed exchange rate is the US dollar. Say the US central bank lowers interest rates to stimulate growth. The interest rate cut encourages international capital flows to high-interest-rate countries such as Indonesia.
The capital inflow causes the demand for the domestic currency to increase. The rupiah exchange rate will tend to appreciate. However, Indonesia’s central bank would intervene in the market because Indonesia adopts a fixed exchange rate.
To offset the increase in demand, the central bank increases the supply of domestic currency. That way, the market equilibrium and the exchange rate are unchanged.
Increasing the supply of domestic currency requires policies to increase the money supply. One option is to lower interest rates.
In other words, to keep the exchange rate fixed, the Indonesian central bank must keep its interest rate spread, with the interest rates in the United States unchanged. If the US central bank cuts interest rates, Indonesia’s central bank must do the same. Likewise, if the US central bank raises interest rates, the Indonesian central bank must also raise interest rates. Such a situation makes the Indonesian central bank dependent on taking policies.
Such dependency may not be the best solution for the domestic economy. Why?
For example, in the above case, if the Indonesian central bank increases the money supply, it would push up the domestic inflation rate. If domestic inflation is still high at that time, such a policy would only increase the upward inflation pressure and could lead to hyperinflation.
Lower foreign reserve requirements
Foreign exchange intervention requires large international reserves for intervention to be credible. And not all countries have it.
Insufficient foreign exchange reserves make the exchange rate vulnerable to speculative attacks. Small attacks can drain foreign reserves in a big way. If there are not enough, the government may have to devalue the exchange rate, which could end in a currency crisis.
On the other side, in the absence of intervention, a pure floating exchange rate system does not require large foreign reserves. Hence, floating exchange rates are suitable for countries with limited foreign exchange reserves, such as countries with negative trade balances.
Disadvantages of pure floating exchange rates
Exchange rate rollercoaster: A pure floating exchange rate can feel like a wild ride for businesses engaged in international trade. The exchange rate can fluctuate significantly due to market forces, making it difficult to plan and price products effectively. Imagine you’re an exporter. A strong domestic currency today might make your goods expensive overseas, hurting your sales. Conversely, a sudden depreciation tomorrow could make your exports cheaper but also increase the cost of imported materials you need for production. This uncertainty about future exchange rates can make budgeting and setting prices a challenge.
Foreign investment on hold: Unpredictable exchange rate movements can also discourage foreign investment. Imagine you’re a foreign investor considering investing in a company in a country with a volatile currency. The risk of your investment losing value due to exchange rate fluctuations might make you think twice. This can hinder a country’s ability to attract foreign capital, which can be crucial for economic growth.
Speculators on the prowl: Pure floating systems can be vulnerable to speculation. Speculators are essentially currency gamblers who try to profit from short-term movements in exchange rates. If they anticipate a currency to depreciate, they might sell it heavily in a coordinated effort, driving the exchange rate down even further. This kind of speculative activity can lead to sharp and potentially disruptive fluctuations in the exchange rate, adding another layer of uncertainty for businesses and investors.
Pure floating vs. managed floating exchange rate
Not all countries embrace the pure floating exchange rate. A managed floating exchange rate system offers a compromise. Governments in this system still allow market forces to influence the exchange rate, but they intervene occasionally to limit excessive fluctuations within a designated band. Imagine a tightrope walker with a safety net – the walker (exchange rate) has some room for movement, but the net (intervention) is there to catch them from falling too far.
The trade-off: The key difference lies in the trade-off between flexibility and stability. A pure floating system offers maximum flexibility for the central bank to conduct monetary policy, but it comes at the cost of higher exchange rate volatility. A managed float offers more stability for businesses and investors, but it restricts the central bank’s ability to adjust interest rates freely.
Choosing the right fit: The decision of which system to adopt depends on a country’s specific priorities. If a country prioritizes promoting international trade and attracting foreign investment, a more stable exchange rate environment offered by a managed float might be preferable. On the other hand, if a country is facing domestic economic challenges and needs more flexibility for its monetary policy, a pure floating system might be a better fit, even with the potential for increased exchange rate volatility.
