Floating Exchange Rate
Overview
A floating exchange rate is a type of exchange rate regime in which a currency's value is allowed to fluctuate in response to foreign exchange market events. A currency that uses a floating exchange rate is known as a floating currency. While these currencies are free to fluctuate in value, the government or central bank may intervene to stabilize the market or promote economic objectives.
History
The concept of floating exchange rates originated in the 20th century. The Bretton Woods system, established in 1944, set the exchange rates for all participating countries relative to gold, effectively creating a fixed exchange rate system. However, this system collapsed in the early 1970s, leading to the adoption of floating exchange rates by many countries.
Mechanics
In a floating exchange rate system, the value of a currency is determined by supply and demand factors in the foreign exchange market. These factors include interest rates, inflation, political stability, economic performance, and speculation. When demand for a currency is high, its value will increase, and vice versa.
Advantages
There are several advantages to using a floating exchange rate system. One of the main benefits is that it allows for automatic adjustments of the exchange rate. This can help a country to absorb economic shocks and maintain its external balance. It also provides the government with more freedom to pursue domestic monetary policy.
Disadvantages
Despite these advantages, floating exchange rates also have their drawbacks. They can be highly volatile, which can lead to economic instability. They can also be influenced by speculation, which can cause rapid and potentially harmful fluctuations in the currency's value.
Intervention in the Foreign Exchange Market
While floating exchange rates are generally left to the market, governments and central banks often intervene to prevent excessive volatility or to achieve economic objectives. This intervention can take the form of buying or selling foreign currency, adjusting interest rates, or implementing capital controls.
Examples
Many of the world's major economies use a floating exchange rate system, including the United States, Canada, and Australia. However, these countries often intervene in the foreign exchange market to manage their currencies.