What’s it: A pure floating exchange rate system is a system of exchange rates in which domestic currency’s value against a foreign currency moves according to a market mechanism. The market mechanism, I mean, is the supply-demand in the foreign exchange market (forex market). Under this system, supply and demand determine the movements of the exchange rates.
Another term for a pure floating exchange rate is the free-floating exchange rate.
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 at the target level, the government actively intervenes in the market.
How the pure floating exchange rate works
In a pure floating system, no intervention is from the governments. The market mechanism works to determine the domestic currency exchange rates.
Changes in demand and supply ultimately move the exchange rate toward equilibrium. When the domestic currency demand is higher than supply, the domestic currency’s exchange rate will appreciate. Appreciation makes the trade balance tend to be 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. This will increase the domestic currency’s purchasing power against foreign currencies (appreciation).
Some countries might adopt managed floating exchange rates. The exchange rate moves freely within a specific range following the forex market’s supply and demand.
But, if the movement became unfavorable, the government intervenes in the market. Such intervention is to avoid sharp fluctuations in the exchange rate, so it supports economic stability.
Factors affecting the 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. Apart from the two, supply and demand are also influenced by speculative activity.
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 causes an appreciation of 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. They then increase demand. As a result, exports increase.
On the other hand, depreciation makes the price of foreign goods more expensive. That reduces imports because domestic consumers tend to reduce demand for foreign goods.
As a result, the trade deficit decreases, and the domestic currency appreciates.
Hope you 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.
Say, the demand for foreign goods is less elastic than the demand for domestic goods. I mean, 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 significant than a decrease in imports. Therefore, the trade balance might turn to a surplus from the previous deficit.
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 of the critical factors 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 be looking 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. Capital inflows increase domestic currency demand. As a result, the domestic currency tends to appreciate.
Pure floating exchange rate advantages
The two advantages of adopting a floating exchange rate are:
- Macroeconomic policy flexibility
- Unrequire large foreign reserves
Macroeconomic policy flexibility
Free-floating exchange rates enable countries to have the ability 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 take 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 rates 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.
Unrequire large foreign reserves
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 it is not enough, it forces the government to devalue the exchange rate. Or, it 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.
Pure floating exchange rate disadvantages
Exchange rates move freely in response to supply and demand conditions on the forex market. As a result, the value of the currency will change over time and make it more volatile.
Also, a speculative activity could cause sharp changes in exchange rates. Too volatile and sharply changing the exchange rate increases the uncertainty in making economic and business decisions.