The floating exchange rate system is an exchange rate system in which the government let the domestic currency to fluctuate in response to demand and supply in the foreign exchange market. This system is the opposite of a fixed exchange rate system. Also known as a flexible exchange rate.
Factors affecting floating exchange rate
In a pure floating system, the government does not intervene the foreign exchange market. It lets the market mechanism to influence the exchange rate of the domestic currency.
Changes in demand and supply eventually move the exchange rate towards equilibrium. When the demand for domestic currency is higher than its supply, the exchange rate of the domestic currency will appreciate. Conversely, the domestic currency will depreciate when its supply is higher than demand.
Most of the countries adopted managed floating exchange rates. In a sense, the exchange rate is left free following the conditions of demand and supply; however, the government also intervenes sometimes. These interventions are to avoid extreme exchange rate fluctuations and to ensure economic stability. The government buys or sells currencies when prices are overvalued or undervalued.
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 when exports increase.
On the contrary, imports depreciate the domestic currency. Domestic consumers ask foreign currencies to pay for imported goods.
Overall, the trade deficit will cause depreciation because import is more significant than export.
Depreciation makes domestic goods cheaper in foreign markets, increasing their exports. Conversely, imported products become more expensive and reduce shipments from abroad. In the end, it will restore equilibrium in the trade balance.
Differences in domestic interest rates with international interest rates affect capital flows, which in turn also influence the exchange rate. When domestic interest rates are too low, relative to international interest rates, capital will come out looking for higher returns abroad. It results in the capital outflow. The capital outflow leads to domestic currency depreciation.
Conversely, when interest rates are relatively high compared to international interest rates, capital inflows due to foreign investors seeking higher returns on the domestic market. As a result, the domestic currency tends to appreciate.
Pros and cons of floating exchange rate system
Two advantages of adopting a floating exchange rate, including:
- Isolate economic policies, regardless of other countries’ policies. The government has the freedom to issue independent policies.
- It does not require vast foreign exchange reserves to maintain exchange rates.
However, flexible exchange rates are vulnerable to extreme fluctuations due to speculative behavior. Vulnerability is even higher in the current era of globalization because more and more countries are connected through international trade and capital flows.
The exchange rate crisis in Indonesia and other Asian countries in 1997/1998 is an example of the adverse effects of speculation by foreign exchange market players.