What is the Floating Exchange Rate?
The floating exchange rate can be defined as the relative value of the currency of a country that is determined on the basis of the demand and the supply factors prevailing in the Forex market and no attempt is made by the government of the country or any other person for influencing such exchange rate.
A Floating exchange rate is nothing but the relative value of one currency concerning another country’s currency which is driven by the speculation as well as the supply and demand forces as prevailing in the market. In the below-mentioned diagram when there is an increase in demand for the pound then the value of Pound to dollar increased from 1 Pound = dollar 1.45 to 1 Pound = dollar 1.55. This is how floating rate changes concerning the demand and supply factors.
How Does it Work?
In case of the system of the floating exchange rate, when currency’s demand is low than its value decreases but at the same time due to this imported goods will become more expensive for the people that are holding the currency and with this people will usually stop importing the goods and would start buying domestic goods and as a result of this more employment will be generated in the economy and thereby stimulating the economy. The vice versa of this also holds wherein case the currency’s demand is more than its value increases but at the same time due to this imported goods will become cheaper for the people that are holding the currency and with this people will usually start importing more goods and would stop buying domestic goods and as a result of this more unemployment will prevail in the economy and thereby cause the slowdown of an economy.
Example of Floating Exchange Rate
The value of 1 United States dollar is equal to 0.78 Pound sterling as on a particular day but a day before the same was 0.76-pound sterling which might increase or decrease the next day based on the demand and supply forces prevailing in the market.
Managed Floating Exchange Rate
It is one that is determined by the private market based on supply and demand in the open market. The managed floating currency rate is similar to the flexible currency rate system. But during heavy and frequent fluctuations in foreign exchange markets, the central bank under a managed floating exchange rate system interferes in the foreign exchange market for purchasing or selling of the currencies to minimize the fluctuations and to keep their currency price favorable for international trade.
Floating Exchange Rate vs Fixed Exchange Rate
The key difference between the two are as follows –
- The fixed exchange rate is the standard rate which is fixed by a monetary authority concerning foreign currency whereas the floating rate in the forex market is determined by demand and supply and it fluctuates constantly.
- The risk in the floating rate is more as compared to a fixed rate.
- Favorable floating forex rate gives the motivation for investment in the foreign market as compared to the fixed forex rate.
- The fixed exchange rate is fixed at an officially set level whereas if the floating exchange rate fluctuates too much then the central bank intervenes to keep it at near to officially set level.
- The floating forex rate is determined by the private market through supply and demand whereas the fixed exchange rate is determined by government/ Central bank as the official exchange rate.
The impacts on different areas are discussed as below:
#1 – Impact on Economy
Currency fluctuations have a direct impact on the monetary policy of the country. Constant currency fluctuations can affect the market adversely and affect the foreign and local trade also.
#2 – Impact on Consumer
Weak currency increases the cost of import and consequently cost is borne by consumers only. On the other hand, stable currency allows consumers to buy more. The best example is oil prices in the international market due to its heavy fluctuations effect on price can be seen clearly.
#3 – Impact on Business
Currency fluctuations affect all kinds of business but the most effective is on export or import business suppliers. Even if the business doesn’t sell or purchase in foreign currency directly these fluctuations can have an unseen effect on that.
The advantages are as follows:
- No Need for International Management of Exchange Rates: As the exchange rate is determined by demand and supply in the market and there is no government intervention until fluctuations are too high.
- No Need for Frequent Central Bank Intervention: Central Bank intervenes frequently in fixed currency regimes whereas in floating currency rate intervention in minimum or only when there are lots of fluctuations.
- Enhances Market Efficiency: The macroeconomic fundamentals of the country affect the exchange rate in international markets which affects the share market of countries which forces countries to perform better and better.
- The benefit of Favourable Market Conditions to Country: It is determined by demand and supply in the market, hence if market conditions are favorable to the country its rate gets increase, and accordingly country gets the benefit of the same.
The disadvantages are as follows:
- Higher Volatility: They are highly volatile hence it affects the trade policy and price of the country directly or indirectly.
- Lack of Investment: higher volatility in exchange rate increase the risk in financial markets hence investors who afford to invest with limited risk won’t afford to invest.
- Worsen Existing Problems: if the country is facing problems like inflation or unemployment or deficit in the balance of trade floating exchange rates may worsen the conditions.
It is the rate that is determined based on supply and demand forces in the market. It fluctuates every day. But if fluctuations are too volatile then the central bank will intervene in the foreign exchange market to control the fluctuations by buying or selling the currency. The fixed exchange rate is determined by the central bank. If a currency is favorable then the floating exchange rate can be beneficial for the country. But due to its volatile nature investors might not want to take higher risks.
This has been a guide to what is Floating Exchange Rate and its definition. Here we discuss floating exchange rates examples, advantages, and disadvantages. You can learn more from the following excel modeling articles –