An exchange rate tells you the price of one currency in terms of another. For example, if you want to know how much 100 US dollars (USD) is in euros (EUR), you’ll need to look at today’s current USD to EUR exchange rate.
But how do countries set their exchange rates in the first place? In most cases, they decide on a type of fixed or floating exchange rate. Here’s a quick look at what floating exchange rates are and how they differ from their fixed counterparts.
What is a floating exchange rate?
Floating exchange rate definition: A type of exchange rate determined by the supply and demand for a country’s currency in the foreign exchange (forex) market. This is different from pegging an exchange rate to another currency or basket of currencies. When the demand for a currency outpaces its supply, its exchange rate will strengthen—and vice versa.
How a floating exchange rate works
What is a floating exchange rate, and how does it work, exactly? Let’s explore how the floating exchange rate system operates.
Imagine you’re trading Pokémon cards on the playground. The rarer a card is, the more other kids want it, and the more they’re willing to trade their own cards for it.
Floating exchange rates work in a similar way, but instead of Pokémon cards, we’re trading currencies. The value of a country’s currency is constantly changing based on supply and demand in the foreign exchange market, which is a giant marketplace for currencies.
Here’s the basic idea:
- High demand, strong currency: If there’s a lot of demand for a country’s currency (because of a strong economy, high interest rates, or stability), people are willing to exchange more of their own currency to get it. This drives the value of that currency up.
- Low demand, weak currency: If there’s less demand for a currency (due to political instability, high inflation, or large national debt), people are less willing to exchange theirs for it. This pushes the value of that currency down.
Think of it like a seesaw on the same playground. More demand for a currency pushes its value up, while less demand pushes its value down.
It’s important to note that there’s no single formula for exchange rates. Many factors can influence them, including:
- Political stability: When a country is seen as politically stable, it attracts foreign investors who want to buy its currency (demand goes up). This can strengthen its currency conversion rate.
- Balance of trade: When a country is exporting more than it’s importing, there’s often high demand for its currency, strengthening its exchange rate.
- Inflation rates: Increasing inflation rates decrease a currency’s purchasing power, which also typically weakens its exchange rate.
- Interest rates: High interest rates bring higher returns on things like bonds and securities, which can attract foreign investments and cause a country’s exchange rate to increase.
- National debt: High levels of public debt can deter foreign investors from buying a country’s currency, which can weaken exchange rates.
- Speculation: Speculation can also cause fluctuations. For instance, if investors anticipate future interest rate hikes, they might buy the currency now, driving up the exchange rate in anticipation.
If a country’s floating exchange rate becomes too volatile, its government can intervene to moderate the rate and prevent future fluctuations. This is called a “dirty float.” For example, a country may buy or sell its own currency and issue public statements to influence other investors in the currency market to do the same.
Pros and cons of a floating exchange rate
Pros of floating exchange rates
Here are some pros of a floating exchange rate system:
- Flexibility: Floating rates can adjust naturally to changing economic conditions. Imagine a country’s economy weakens. A weaker currency caused by reduced demand makes the country’s exports cheaper on the global market. This can boost exports and stimulate economic growth.
- Monetary policy independence: Countries with floating exchange rates can set their interest rates to manage inflation or unemployment without worrying about maintaining a fixed exchange rate. For example, if inflation rises, the central bank can raise interest rates to cool things down, even if it affects the exchange rate.
- Trade competitiveness: A weaker currency can give a country a significant edge in international trade. Cheaper exports make them more attractive to foreign buyers, potentially increasing export sales and boosting economic activity. This can be a powerful tool, especially for countries that rely heavily on exports.
Let’s look at a real-world example of how a floating exchange rate can provide a country with flexibility and monetary control: An oil price drop in 2014 caused many Canadians in energy-producing provinces to lose their jobs. However, by allowing its dollar to drop with the oil price, Canada saw an estimated 900,000 more jobs created in manufacturing and other export-producing industries.
Cons of floating exchange rates
Floating exchange rates offer flexibility, but they also come with some drawbacks:
· Higher volatility: Unlike fixed rates, floating rates can fluctuate a lot due to various economic and political factors. This volatility can make it challenging for businesses to plan, especially when entering international markets or dealing in foreign currencies. Imagine trying to set prices for your exports if the exchange rate keeps jumping around—it’s difficult to know how much revenue you’ll earn.
· Susceptibility to speculation: The foreign exchange market is large and complex, attracting a lot of speculation by investors. These speculators can make big bets on future currency movements, which can cause sharp and unpredictable changes in exchange rates. This can be disruptive for businesses and economies, as sudden currency swings can disrupt trade and investment.
· Currency manipulation: While governments generally avoid direct intervention, they can still influence exchange rates to some extent. Some countries might try to weaken their currency artificially to gain a trade advantage (cheaper exports). This can create tension between countries and disrupt the stability of the global financial system.
Fixed vs. floating exchange rate
The International Monetary Fund (IMF) puts foreign exchange rates into two primary categories: fixed and floating.
Fixed exchange rates essentially peg a currency’s value to another currency or a basket of currencies, allowing for minimal fluctuations. Floating exchange rates are determined by market forces like supply and demand. While governments can intervene to manage excessive volatility, floating rates generally reflect underlying economic health.
| Fixed Exchange Rate | Floating Exchange Rate | |
| Control | More control. The government pegs its rate to another currency, or a basket of currencies, and restricts fluctuations. | Less control. The rate is determined by the supply and demand in the market, without limits. Governments can take steps to intervene if it becomes too volatile. |
| Volatility | Low risk of volatility | High risk of volatility |
| Economic Impact | Fixed exchange rates can encourage policy discipline, increase confidence in a currency, and keep inflation rates down long term. | Floating exchange rates can act as a buffer to insulate a country’s economy from shocks, remove the need for large reserves, and grant countries monetary policy independence. |
Examples of floating exchange rates
As of 2022, 66 of 190 countries in the IMF had de facto floating exchange rate systems, including:
- United States
- Australia
- Canada
- Japan
- United Kingdom
- Sweden
- European Economic and Monetary Union
To see how floating exchange rates behave, you can check the Federal Reserve’s historical foreign exchange rate data. For example, when looking at the USD per Great British pound (GBP) exchange rate since 2020, you’ll find daily fluctuations as well as larger rate shifts over time.
Floating exchange rates historically
From 1870 to 1914, the gold standard was the main monetary system, with most of the world’s currencies pegged to gold or gold-backed currencies. World War I disrupted this system, as countries prioritized financing the war effort over maintaining gold convertibility.
The Great Depression further exposed the weaknesses of the gold standard, leading many countries, including the United Kingdom, to abandon it completely.
The Bretton Woods system, established in 1944, aimed to create a more stable international monetary system. Initially, it pegged currencies to gold, with the US dollar acting as the world’s reserve currency and convertible to gold at a fixed rate.
However, as the US economy grew and the global demand for dollars increased, the system came under strain. The overvaluation of the US dollar and dwindling US gold reserves ultimately led to the system’s collapse in 1971. A brief attempt to revive it failed in 1973.
Since 1973, members of the IMF have been free to choose from various foreign exchange rate types, excluding pegging currencies to gold.
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FAQs
What is meant by a floating exchange rate?
A floating exchange rate is a type of foreign exchange rate that fluctuates based on supply and demand in the foreign exchange market. Unlike fixed rates, it’s not pegged to another country’s currency, so it’s subject to greater fluctuations.
What’s the difference between floating and fixed exchange rates?
Fixed foreign exchange rates are pegged to another country’s currency, while floating exchange rates fluctuate based on supply and demand in the foreign exchange market.
What is an example of a floating currency?
Many of the world’s leading currencies are floating, including the US dollar, Australian dollar, Canadian dollar, EU euro, Japanese yen, and British pound. With any of these currencies, you can expect fluctuations in the exchange rate daily.
