Floating exchange rate system

Floating exchange rate system
See also
Fixed exchange rate Monetary base Buffer stock Currency Convertibility Major currencies Reserve ratio Bank reserve requirements Stabilization policy Interest rate parity

A floating exchange rate system is a system where exchange rates are determined by the market forces of supply and demand. It operates as a free-floating system, with no central bank or government intervention, and is considered to be the most flexible and market-oriented of all exchange rate regimes.

The main features of a floating exchange rate system are:

• Exchange rates are determined by the market forces of supply and demand. This means that the exchange rate will be affected by factors such as the relative demand for a particular currency, the relative inflation rates of two countries, and the relative interest rates of two countries.
• There is no central bank or government intervention in the exchange rate. This means that the exchange rate is determined solely by the market and not by government policy.
• The exchange rate is flexible and can change daily, depending on market conditions.
• There is no fixed exchange rate. This means that the value of one currency in relation to another is constantly fluctuating as the market forces of supply and demand dictate.

In summary, a floating exchange rate system is a system where exchange rates are determined by the market forces of supply and demand, without any central bank or government intervention. This system is considered to be the most flexible and market-oriented of all exchange rate regimes.

Example of Floating exchange rate system

The US dollar-Japanese yen exchange rate is a good example of a floating exchange rate system. The exchange rate between the two currencies is determined by the market forces of supply and demand, without any government intervention. The value of the US dollar in relation to the Japanese yen is constantly fluctuating, depending on the relative demand for each currency, the relative inflation rates, and the relative interest rates.

When to use Floating exchange rate system

A floating exchange rate system is the most suitable exchange rate regime to use in cases where there is a high degree of volatility in exchange rates or in cases where a country needs to maintain a certain level of economic stability. This system is also preferable for countries that are open to international trade, as it allows for more flexibility in the exchange rate and allows for the adjustment of the exchange rate in response to market forces. Additionally, this system is suitable for countries that have a freely convertible currency, as it allows for more efficient allocation of capital and investment.

Types of Floating exchange rate system

• Managed Float: In a managed float, the central bank or government intervenes in the exchange rate, buying or selling currency to manipulate the exchange rate. This type of system is sometimes referred to as a “dirty float”.
• Free Float: In a free float, the exchange rate is determined solely by the market forces of supply and demand. This type of system is considered to be the most market-oriented of all exchange rate regimes.

Steps of Floating exchange rate system

The steps of a floating exchange rate system include:

• Determining the value of a currency: The value of a currency is determined by the market forces of supply and demand. This means that the exchange rate will be affected by factors such as the relative demand for a particular currency, the relative inflation rates of two countries, and the relative interest rates of two countries.
• Floating the exchange rate: The exchange rate is allowed to fluctuate freely, with no government or central bank intervention. This means that the exchange rate will be determined solely by the market forces of supply and demand.
• Monitoring the exchange rate: The exchange rate should be monitored regularly to ensure that it is in line with market conditions.
• Adjusting the exchange rate: If the exchange rate is not in line with market conditions, the central bank may intervene to adjust the exchange rate.

Advantages of Floating exchange rate system

The main advantages of a floating exchange rate system are:

• Exchange rates are determined by the market forces of supply and demand, meaning the rate is constantly adjusted to reflect changing economic and financial conditions.
• It provides a more stable and predictable environment for international trade.
• It provides an efficient mechanism for international capital flows.
• It is more responsive to economic changes, and can help to reduce the risk of inflationary pressures.

Limitations of Floating exchange rate system

The main limitations of a floating exchange rate system are:

• Exchange rate uncertainty: The exchange rate is constantly fluctuating and can be unpredictable, making it difficult for businesses to plan for the future.
• Balance of payments problems: A floating exchange rate system can lead to large swings in the balance of payments, which can cause economic instability.
• Difficulty in meeting international obligations: A floating exchange rate system can make it difficult for countries to meet their international obligations, as the exchange rate can change rapidly and unexpectedly.
• Exchange rate manipulation: Countries with floating exchange rates may attempt to manipulate the exchange rate to their advantage, which can lead to currency wars and economic instability.

Other approaches related to Floating exchange rate system

A fixed exchange rate system is an exchange rate system where the value of a currency is fixed relative to a foreign currency, usually a major currency such as the US dollar or Euro. This system is also known as a pegged exchange rate system, and it can be either a managed or a hard peg.

The main features of a fixed exchange rate system are:

• Exchange rates are fixed relative to a foreign currency. The currency will maintain its fixed rate against the foreign currency, even if market forces would lead to a different exchange rate.
• There is usually some form of central bank or government intervention in order to maintain the fixed rate. This could involve buying or selling currency in order to maintain the fixed rate.
• The fixed exchange rate system can be either a managed or a hard peg. A managed peg means that the exchange rate is allowed to fluctuate within a certain range, while a hard peg means that the exchange rate is fixed at a certain level and will not be allowed to fluctuate.

In summary, a fixed exchange rate system is an exchange rate system where the value of a currency is fixed relative to a foreign currency, usually with some form of central bank or government intervention. This system can be either a managed or a hard peg, depending on the desired level of stability.

Suggested literature

• Edwards, S. (1983). Floating exchange rates, expectations and new information. Journal of Monetary Economics, 11(3), 321-336.
• Devereux, M. B., & Engel, C. (1998). Fixed vs. floating exchange rates: How price setting affects the optimal choice of exchange-rate regime.