A floating exchange rate is an exchange rate system where a country’s currency price is determined by the foreign exchange market, depending on the relative supply and demand of other currencies. A floating exchange rate is not restrained by trade limits or government controls, unlike a fixed exchange rate.
A floating exchange rate refers to an exchange rate system where a country’s currency price is determined by the relative supply and demand of other currencies.
Currencies with floating exchange rates can be traded without any restrictions, unlike currencies with fixed exchange rates.
Although the floating exchange rate is not entirely determined by the government and central banks, they can intervene to keep the currency at a favorable price for global trade.
Functions of a Floating Exchange Rate
A floating exchange rate functions in an open market where speculations, along with demand and supply forces, drive the price. Floating exchange rate structures mean that changes in long-term currency prices represent comparative economic strength and differences in interest rates across countries. Changes in the short-term floating exchange rate represent disasters, speculations, and the daily supply and demand of the currency.
In the graph below, an increased currency supply from S1 to S2 at the same demand D1 implies that the currency-pair price will depreciate. In contrast, increased demand from D1 to D2 at the same supply S1 will lead to currency appreciation.
Market sentiment towards the economy of a country affects how strong or weak the floating currency is perceived. For example, a country’s currency is expected to depreciate if the market views the government as unstable. Although the floating exchange rate is not entirely determined by the government, they can intervene when the currency is too low or too high to keep the currency at a favorable price.
Benefits of a Floating Exchange Rate
1. Stability in the balance of payments (BOP)
A balance of payments is in the statement of transactions between entities of a country and the entities of the rest of the world over a time period. In theory, any imbalance in that statement automatically changes the exchange rate.
For example, if the imbalance is a deficit, it would cause the currency to depreciate. The country’s exports would become cheaper, resulting in an increase in demand and eventually attaining equilibrium in the BOP.
2. Foreign exchange is unrestricted
Floating exchange rate currencies can be traded without any restrictions, unlike currencies with fixed exchange rates. Hence, governments and banks do not need to resort to a continuous management process.
3. Market efficiency enhances
A country’s macroeconomic fundamentals affect the floating exchange rate in global markets, influencing the flow of portfolios between countries. Thus, floating exchange rates enhance the efficiency of the market.
4. Large foreign exchange reserves not required
For a floating exchange rate, central banks are not required to keep large foreign currency reserve amounts for defending the exchange rate. Hence, the reserves can be utilized for promoting economic growth by importing capital goods.
5. Import inflation protected
Countries with fixed exchange rates face the problem of importing inflation through surpluses of the balance of payments or higher prices of imports. However, countries with floating exchange rates do not face such a problem.
Limitations of a Floating Exchange Rate
1. Exposed to the volatility of the exchange rate
Floating exchange rates are prone to fluctuations and are highly volatile by nature. A currency value against another currency may deteriorate only in one trading day. Furthermore, the short-term volatility in a floating exchange rate cannot be explained through macroeconomic fundamentals.
2. Restricted economic growth or recovery
The lack of control over floating exchange rates can limit economic growth or recovery. The negative currency exchange rate movements may lead to serious issues. For example, if the dollar rises against the euro, it will be more difficult to export to the eurozone from the U.S.
3. Existing issues may worsen
If a country is suffering from economic issues, such as unemployment or high inflation, floating exchange rates may intensify the existing problems. For example, depreciation of a country’s currency already suffering from high inflation will cause inflation to increase further due to an increase in demand for goods. Moreover, expensive imports may worsen the country’s current account.
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