Floating exchange rate
A country's exchange rate regime where its currency is set by the foreign-exchange market through supply and demand for that particular currency relative to other currencies. Thus, floating exchange rates change freely and are determined by trading in the forex market. This is in contrast to a "fixed exchange rate" regime.
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In some instances, if a currency value moves in any one direction at a rapid and sustained rate, central banks intervene by buying and selling its own currency reserves (i.e. Federal Reserve in the U.S.) in the foreign-exchange market in order to stabilize the local currency. However, central banks are reluctant to intervene, unless absolutely necessary, in a floating regime.
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Exchange Rate system in which rates of each national currency are determined by interaction of market supply and demand. Factors affecting demand and supply of each currency include a country's Current Account balance, the general strength of its economy, its rate of Inflation and interest rates as compared against other nations.
In the years since 1971 when the United States finally abandoned the fixed exchange rate system and convertibility of the dollar into gold, most world currencies have traded at floating, or flexible, exchange rates. A downside to the floating exchange rate system is that central banks have to intervene in the markets from time to time, by buying or selling currencies to keep exchange rates from getting too high or too low. Clean Float currency has a minimum of official intervention, except to maintain market stability, and its exchange rate is mostly determined by market demand. Dirty Float on the other hand, denotes a varying amount of official Intervention to keep a nation's currency within a desired range of currency prices in relation to other currencies. See also Convertibility; Exchange Controls; Fixed Exchange Rates.
International monetary exchange system in which the prices of currencies are determined by competitive market forces; after 1971 exchange rates between the dollar and other foreign currencies were allowed to float. Under this system, rates, which are determined by the supply and demand for foreign exchange, can change from moment to moment.
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A floating exchange rate or fluctuating exchange rate is a type of exchange rate regime wherein a currency's value is allowed to fluctuate according to the foreign exchange market. A currency that uses a floating exchange rate is known as a floating currency. It is not possible for a developing country to maintain the stability in the rate of exchange for its currency in the exchange market.
There are economists who think that, in most circumstances, floating exchange rates are preferable to fixed exchange rates. As floating exchange rates automatically adjust, they enable a country to dampen the impact of shocks and foreign business cycles, and to preempt the possibility of having a balance of payments crisis. However, in certain situations, fixed exchange rates may be preferable for their greater stability and certainty. This may not necessarily be true, considering the results of countries that attempt to keep the prices of their currency "strong" or "high" relative to others, such as the UK or the Southeast Asia countries before the Asian currency crisis. The debate of making a choice between fixed and floating exchange rate regimes is set forth by the Mundell-Fleming model, which argues that an economy cannot simultaneously maintain a fixed exchange rate, free capital movement, and an independent monetary policy. It can choose any two for control, and leave third to the market forces.
In cases of extreme appreciation or depreciation, a central bank will normally intervene to stabilize the currency. Thus, the exchange rate regimes of floating currencies may more technically be known as a managed float. A central bank might, for instance, allow a currency price to float freely between an upper and lower bound, a price "ceiling" and "floor". Management by the central bank may take the form of buying or selling large lots in order to provide price support or resistance, or, in the case of some national currencies, there may be legal penalties for trading outside these bounds.
Fear of floating
A free floating exchange rate increases foreign exchange volatility. There are economists who think that this could cause serious problems, especially in emerging economies. These economies have a financial sector with one or more of following conditions:
- high liability dollarization
- financial fragility
- strong balance sheet effects
When liabilities are denominated in foreign currencies while assets are in the local currency, unexpected depreciations of the exchange rate deteriorate bank and corporate balance sheets and threaten the stability of the domestic financial system.
For this reason emerging countries appear to face greater fear of floating, as they have much smaller variations of the nominal exchange rate, yet face bigger shocks and interest rate and reserve movements.[1] This is the consequence of frequent free floating countries' reaction to exchange rate movements with monetary policy and/or intervention in the foreign exchange market.
The number of countries that present fear of floating increased significantly during the nineties.[2]
See also
References
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- Fixed Exchange Rate (business term)
- Peg (business term)
- Revaluation (finance term)
- Peg (Pegging) (in banking)
- Floating Currency Exchange Rate (business term)
- Interest Rate Swap (in banking)
- Swap (finance term)
- Currency band
- Floating currency
- Economic Policy and Theory (US foreign policy)
- Exchange rate regime
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