A floating exchange rate refers to an exchange rate system in which supply-demand on the foreign exchange (forex) market determines the price of a country’s currency. The government does not intervene in the market at all to influence the exchange rate of the domestic currency.
Free-floating exchange rates sometimes referred to as clean or pure float or flexible exchange rates. Its free movement enables the exchange rate to adjust and correct imbalances, such as the current account deficit.
In a floating exchange rate, the value of currency continues to fluctuate according to the fundamentals of demand and supply. Even small speculative behaviors also contribute to fluctuations.
A floating exchange rate is the opposite of a fixed exchange rate. In this regime, the exchange rate is not left to market mechanisms; rather, the government defines it. The fixed exchange rate system requires active government intervention, which is done by buying and selling currencies on the forex market.
From 1946 to the early 1970s, the Bretton Woods system made fixed currency the norm. However, in 1971, many countries abandoned it and decided to enforce a fixed exchange rate no longer.
How does a floating exchange rate affect the economy?
A floating exchange rate system means changes in long-term currency prices that reflect relative economic strength and differences in interest rates between countries. A currency that is too low or too high can negatively affect the economy, which affects a country’s trade and the ability to pay debts.
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Why is a floating exchange rate better?
A floating exchange rate has several benefits. In this system, the exchange rate better reflects the real value of a currency. That is because the price of the exchange rate is determined by its supply-demand equilibrium on the forex market.
Flexible exchange rates support readjustment in the balance of payments. When depreciation occurs, the exchange rate makes domestic goods cheaper on foreign markets and imported goods more expensive on the domestic market. As a result, imports decrease and exports increase. Increased exports and reduced imports mean higher demand for domestic currency, leading to appreciation. Then, appreciation makes domestic goods more expensive and imported goods cheaper. Thus, flexible exchange rates allow a balanced balance sheet.
Another advantage of floating exchange rates is:
- Allow the implementation of an independent monetary policy. The central bank is not tied its economic policies to trading partners’ policy, for example, in determining interest rates.
- Promote economic development by allowing the free flow of international capital
- Does not require sizeable foreign exchange reserves for intervention because the exchange rate is left to the market mechanism
Why is the floating exchange rate worse?
The floating exchange rate regime makes the currency more volatile. Fluctuations bring instability in the economy and uncertainty in the economic decision by economic agents. For example, it is difficult for businesses to make economic decisions because the exchange rate moves unexpectedly.
Market mechanisms do not always lead to ideal conditions for the economy as speculative attacks could bring disaster to the economy. Such an attack could bring the economy into a financial crisis like the 1997 Asian financial crisis.