Floating Exchange Rate

Article byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

What Is Floating Exchange Rate?

The floating exchange rate can be defined as the relative value of a country’s currency determined based on the demand and supply factors prevailing in the Forex market. No attempt is made by the country’s government or any other person to influence such an exchange rate.

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It is the rate determined based on supply and demand forces in the market. It fluctuates every day. But if fluctuations are too volatile, the Central Bank will intervene in the foreign exchangeForeign ExchangeForeign exchange, or Forex, is trading one currency for values equivalent to another currency.read more market to control the changes by buying or selling the currency. The Central Bank determines the fixed exchange rate. If a currency is favorable, the floating exchange rate can benefit the country. But due to its volatile nature, investors might not want to take higher risks.

Key Takeaways

  • The relative worth of the nation’s currency, as determined by the supply and demand conditions dominating the foreign exchange market, is what is known as the floating exchange rate. 
  • One benefit of a floating exchange rate is that it eliminates the need for central bank involvement frequently and removes the need for international currency rate management. 
  • The drawbacks of this exchange rate include increased volatility, a lack of investment, a worsening of issues like inflation, unemployment, or a deficit in the balance of trade. 
  • The forces of supply and demand in the market are used to set the floating exchange rate.

Floating Exchange Rate Explained

The floating exchange rate, also called the flexible exchange rate, is a regime in which a country is currency value depends on the foreign exchange market, where the currency’s demand and supply occur. Under this system, in floating exchange rate countries, the exchange rate is not pegged or fixed to a particular value. Therefore it can fluctuate very quickly depending on the forces of the market.

In the case of the floating exchange rate system, when the currency’s demand is low, its value decreases, but at the same time, due to this, imported goods will become more expensive for the people holding the currency. With this, people will usually stop importing the goods and start buying domestic goods. As a result, more employment will be generated, thereby stimulating the economyEconomyAn economy comprises individuals, commercial entities, and the government involved in the production, distribution, exchange, and consumption of products and services in a society.read more. The vice versa of this also holds wherein the currency’s demand is more than its value increases. However, at the same time, due to this, imported goods will become cheaper for the people holding the currency. With this, people will usually start importing more goods. As a result, they would stop buying domestic goods. Subsequently, more unemployment will prevail in the economy and thereby cause a slowdown in the economy.

The market determines the process of floating exchange rate regime, which means that factors like interest rates, political and economic stability, inflation, global market condition, etc, strongly influence it. There is no government intervention except in the managed floating exchange rate, which involves intervention to some extent. It is allowed to adjust as per the market movements. However, due to the influence of fluctuations, the volatility factor cannot be ruled out for short periods. This can again impact the trades, international investments, or financial transactions with other countries,

However, exchange rate adjustments can stabilize the economy, making it more competitive for exports and imports. Most of the economies have some form of floating exchange rate, where there is occasional intervention of central banks to control fluctuations.

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Types

The concept can be further classified used two different types. Let us understand them in details.

  • Free Floating Exchange Rate – In this system, the currency value is determined by the market forces. The central bank does no interfere and it has no specific target to try and stabilize the fluctuations. The market forces fix it. Therefre, there is an automatic adjustement which helps in balancing the trade. The resources are allocated in an optimum way making the market more efficient. The country’s economic and financial condition becomes transparent. Howwever, due to fluctuations, speculation takes place creating sharp currency movement and uncertainty.
  • Managed Floating Exchange Rate – This is also known as dirty float, where the rate is allowed to be volatile, but the central bank intervenes in the foreign exchange market to control the currency value upto a certain extent. It uses various monetary tools to stabilize it. This system of managed floating exchange rate offers more stability, flexibility and less speculation. But is the central bank’s intervention is not properly timed and coordinated, it may create uncertainty or unintended consequences.

The above are the two main types of floating exchange rates. But floating exchange rate countries may adopt or change their systems depending on the economic conditions or government policies.

Example

A floating exchange rate is the relative value of one currency concerning another country’s currency, driven by the speculation and supply and demand forces prevailing in the market. Let us understand the concept of a floating exchange rate regime with the help of some examples.

Example #1

For example, in the below-mentioned diagram, when there is an increase in the pound’s demand, the pound to dollar increases from 1 Pound = Dollar 1.45 to 1 Pound = Dollar 1.55. That is how the floating rate changes concerning the demand and supply factors. 

Floating Exchange Rate

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Example #2

1 United States Dollar equals 0.78 Pound Sterling 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

The private market determines it 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 marketsForeign Exchange MarketsThe foreign exchange market is the world’s largest financial market that decides the exchange rate of currencies.read more, the Central Bank, under a managed floating exchange rate system, interferes in the foreign exchange market to purchase or sell the currencies to minimize the fluctuations and keep their currency price favorable for international tradeInternational TradeInternational Trade refers to the trading or exchange of goods and or services across international borders. read more.

Impact

The impacts on different areas are discussed below:

Impact-of-FER

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#1 – Impact on Economy

Currency fluctuations have a direct impact on the monetary policy of the country Monetary Policy Of The CountryMonetary policy refers to the steps taken by a country’s central bank to control the money supply for economic stability. For example, policymakers manipulate money circulation for increasing employment, GDP, price stability by using tools such as interest rates, reserves, bonds, etc.read more. Constant currency fluctuations can adversely affect the market and foreign and local trade.

#2 – Impact on Consumer

Weak currency increases the cost of imports. Consequently, the charge is borne by consumers only. On the other hand, a 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 company does not sell or purchase foreign currency directly, these fluctuations can be unseen.

Advantages

The advantages are as follows:

Disadvantages

The disadvantages are as follows:

Floating Exchange Rate Vs Fixed Exchange Rate

The key difference between the two is as follows:

Frequently Asked Questions (FAQs)

What is the dirty floating exchange rate?

The dirty floating exchange rate refers to the floating exchange rate where the Central Bank seldom interferes with altering the management or changing the country’s currency value movement.

What is a managed floating exchange rate?

A managed floating exchange rate refers to the exchange rate system that enables a country’s Central Bank to interfere in the foreign exchange market to alter the movement of the currency’s float/or diminish the currency volatility amount. In addition, it is also referred to as a “dirt float.”

What is a pure floating exchange rate?

A pure floating exchange rate refers to the floating exchange rate determined without any government or Central Bank interference.

How does a floating exchange rate affect the economy?

These exchange rates can fluctuate freely in response to changes in the economy without any intervention from the government. However, there are a few ways in which this exchange rate affects the economy, like trade, inflation, investment, and debt. 

Recommended Articles

This article is a guide to what is Floating Exchange Rate. We explain the differences with fixed exchange rate, advantages, disadvantages, examples & types. You can learn more from the following Excel modeling articles: –

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