Floating exchange rate system

Floating exchange rate system is a currency regime in which the value of a nation's money is determined by foreign exchange market forces rather than being fixed by government policy or pegged to another currency ^[1]. Under this arrangement, exchange rates fluctuate continuously based on supply and demand for different currencies. Most major economies including the United States, European Union, Japan, United Kingdom and Australia operate under some form of floating exchange rate. The system contrasts with fixed exchange rate regimes where central banks commit to maintaining predetermined currency values through market intervention.

Historical development

The modern floating exchange rate era began following the collapse of the Bretton Woods system in 1971. After World War II, participating nations had agreed to maintain fixed exchange rates with currencies pegged to the United States dollar, which was convertible to gold at thirty-five dollars per ounce ^[2]. This arrangement provided stability for international trade and investment during the postwar reconstruction period.

Growing imbalances undermined the Bretton Woods system by the late 1960s. The United States experienced inflation and trade deficits that made the fixed dollar-gold price increasingly untenable. On August 15, 1971, President Richard Nixon suspended dollar convertibility to gold, effectively ending the fixed rate system. The Smithsonian Agreement of December 1971 attempted to establish new fixed rates but these proved unsustainable ^[3].

By 1973, major currencies began floating against each other. The transition occurred somewhat chaotically as policymakers and markets adapted to the new environment. The International Monetary Fund officially recognized floating exchange rates in its 1978 amendment to the Articles of Agreement, acknowledging the reality that had already emerged.

Types of floating systems

Free floating

In a purely free floating regime, market forces alone determine exchange rates without any government intervention. The central bank takes no action to influence the currency's value, allowing supply and demand to establish equilibrium prices ^[4]. Very few countries practice completely free floating in reality, as most reserve the option to intervene under extreme circumstances.

Free floating represents the theoretical ideal in which market mechanisms efficiently allocate capital across borders. Currency values adjust to reflect differences in inflation rates, interest rates, productivity growth and other economic fundamentals. No foreign exchange reserves are needed for intervention purposes.

Managed floating

Managed floating, sometimes called dirty floating, allows market forces to determine exchange rates within boundaries but permits official intervention to smooth excessive volatility or prevent disorderly conditions ^[5]. Central banks may buy or sell foreign currencies to influence their own currency's value without committing to specific target levels.

The degree of management varies considerably. Some central banks intervene rarely and only during extreme market disruption. Others actively seek to prevent excessive appreciation or depreciation that might harm economic interests. Intervention may occur openly with public announcement or secretly to maintain uncertainty about official intentions.

Most major floating currencies operate under managed float arrangements. Even countries officially committed to free floating maintain capacity to intervene and do so on occasion. The line between managed floating and free floating proves difficult to draw precisely.

Mechanics of exchange rate determination

Supply and demand factors

Currency values under floating regimes reflect relative supply and demand in foreign exchange markets ^[6]. Demand for a currency arises from exports of goods and services, inflows of foreign investment, tourism spending by foreigners and speculative purchases. Supply comes from imports, outbound investment, foreign travel by residents and speculative selling.

When demand exceeds supply, the currency appreciates. Increased export competitiveness, higher interest rates attracting foreign capital or expectations of future appreciation all boost demand. When supply exceeds demand, depreciation occurs. Trade deficits, capital outflows or loss of investor confidence increase selling pressure.

Interest rate differentials

Differences in interest rates between countries significantly influence exchange rate movements. Higher rates attract capital inflows as investors seek better returns, increasing demand for the currency and causing appreciation ^[7]. Lower rates relative to trading partners encourage outflows and depreciation.

Central bank decisions regarding monetary policy therefore affect exchange rates. Rate increases to combat inflation tend to strengthen currencies while rate cuts to stimulate growth tend to weaken them. Market expectations about future rate changes influence current exchange rates as traders position for anticipated moves.

Inflation differentials

Over longer periods, relative inflation rates between countries drive exchange rate trends. A country with higher inflation than its trading partners tends to experience currency depreciation. Higher domestic prices make exports less competitive and imports more attractive, increasing supply of the local currency relative to demand ^[8].

Purchasing power parity theory holds that exchange rates should adjust to equalize the purchasing power of different currencies over time. While not holding precisely in short periods, inflation differentials do explain much of long-term exchange rate movement.

Advantages of floating exchange rates

Monetary policy independence

Floating rates allow central banks to conduct monetary policy focused on domestic objectives such as controlling inflation or managing employment ^[9]. Under fixed rates, monetary policy becomes subordinated to maintaining the exchange rate peg. Interest rates cannot differ significantly from anchor currency rates without creating irresistible pressure on the fixed rate.

Countries with floating rates can raise interest rates to cool overheating economies or lower them to stimulate activity without concern for exchange rate commitments. This flexibility proved valuable during the 2008 financial crisis when many central banks slashed rates and engaged in quantitative easing that would have been impossible under fixed rate constraints.

Automatic adjustment

Balance of payments imbalances trigger automatic adjustment through exchange rate movements. A country running trade deficits experiences currency depreciation that makes exports cheaper and imports more expensive, naturally correcting the imbalance ^[10]. Surplus countries see appreciation that reduces export competitiveness and encourages imports.

This mechanism operates continuously without requiring deliberate policy action. Under fixed rates, adjustment must occur through internal deflation (reducing wages and prices) or external borrowing to finance deficits. Both alternatives prove slower and more painful than exchange rate adjustment.

Shock absorption

External economic shocks transmit less forcefully to domestic economies under floating rates. A negative shock depreciates the currency, providing offsetting stimulus through improved export competitiveness ^[11]. Countries with fixed rates cannot access this cushioning mechanism and must absorb shocks through internal adjustment.

The Asian financial crisis of 1997-1998 demonstrated this effect. Countries maintaining currency pegs experienced severe disruption when attacked by speculators. Those that allowed currencies to float absorbed the shock more readily and recovered faster.

Reduced reserve requirements

Fixed exchange rate systems require central banks to hold substantial foreign currency reserves for intervention. Defending pegs during speculative attacks can rapidly deplete these reserves. Floating regimes dramatically reduce or eliminate this need, freeing resources for other productive uses ^[12].

Disadvantages of floating exchange rates

Volatility and uncertainty

Exchange rate fluctuations introduce uncertainty into international trade and investment. Exporters cannot know with certainty what domestic currency they will receive for foreign sales. Importers face unpredictable costs. Foreign investors risk losing returns to adverse currency movements ^[13].

This uncertainty imposes costs on businesses that must hedge currency exposure or accept the risk. Small and medium enterprises lacking access to sophisticated hedging instruments may avoid international activities entirely. Even large corporations find exchange rate volatility complicates planning and budgeting.

Reduced discipline

Fixed exchange rates impose discipline on domestic policies by preventing inflationary monetary expansion. Excessive money creation triggers reserve losses as traders convert the depreciating currency. Floating rates remove this external constraint, potentially enabling irresponsible policies ^[14].

Countries with poor institutions or weak central bank independence may find floating rates enable rather than constrain inflationary tendencies. The discipline must come from internal commitment to sound policy rather than external market pressures.

Overshooting

Exchange rates can move far beyond levels justified by economic fundamentals, overshooting equilibrium values before eventually correcting. Speculative dynamics, herd behavior and momentum trading amplify movements beyond what fundamentals warrant ^[15].

Overshooting creates real economic distortions. Excessive appreciation damages export industries that may not recover when the currency eventually corrects. Excessive depreciation generates inflationary pressures and strains for import-dependent sectors.

Floating exchange rate system — recommended articles

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References

• Eichengreen B. (2019), Globalizing Capital: A History of the International Monetary System, 3rd Edition, Princeton University Press.
• Frankel J.A. (1999), No Single Currency Regime is Right for All Countries or at All Times, NBER Working Paper No. 7338.
• Friedman M. (1953), Essays in Positive Economics, University of Chicago Press.
• Krugman P.R., Obstfeld M., Melitz M.J. (2018), International Economics: Theory and Policy, 11th Edition, Pearson.
• Mishkin F.S. (2018), The Economics of Money, Banking, and Financial Markets, 12th Edition, Pearson.
• Obstfeld M., Rogoff K. (1996), Foundations of International Macroeconomics, MIT Press.
• Taylor J.B., Taylor A.M. (2004), The Purchasing Power Parity Debate, Journal of Economic Perspectives, Vol. 18, No. 4, pp. 135-158.

Footnotes

1. Krugman P.R., Obstfeld M., Melitz M.J. (2018), pp. 456-472
2. Eichengreen B. (2019), pp. 134-156
3. Obstfeld M., Rogoff K. (1996), pp. 178-195
4. Mishkin F.S. (2018), pp. 412-425
5. Frankel J.A. (1999), pp. 12-18
6. Krugman P.R., Obstfeld M., Melitz M.J. (2018), pp. 478-492
7. Mishkin F.S. (2018), pp. 435-448
8. Taylor J.B., Taylor A.M. (2004), pp. 135-158
9. Friedman M. (1953), pp. 157-203
10. Obstfeld M., Rogoff K. (1996), pp. 234-256
11. Eichengreen B. (2019), pp. 212-234
12. Krugman P.R., Obstfeld M., Melitz M.J. (2018), pp. 512-526
13. Frankel J.A. (1999), pp. 24-32
14. Mishkin F.S. (2018), pp. 452-468
15. Obstfeld M., Rogoff K. (1996), pp. 312-328

Author: Sławomir Wawak