What is a floating exchange rate?
A floating exchange rate is a regime where the price of a country’s currencies is set by the foreign exchange market based on supply and demand relative to other currencies. This contrasts with a fixed exchange rate, in which the government determines the rate entirely or mainly.
Floating exchange rate
Key points to remember
- A floating exchange rate is one that is determined by supply and demand in the free market.
- A floating exchange rate does not mean that countries are not trying to intervene and manipulate the price of their currency, as governments and central banks regularly try to keep their prices favorable to international trade.
- A fixed exchange is another model of currency, and this is where a currency is indexed or held at the same value against another currency.
- Floating exchange rates became more popular after the failure of the gold standard and the Bretton Woods agreement.
How a floating exchange rate works
Floating exchange rate systems mean that long-term changes in currency prices reflect relative economic strength and interest rate spreads between countries.
Short-term movements in a currency with a floating exchange rate reflect speculation, rumors, disasters and the daily supply and demand for the currency. If supply exceeds demand, this currency will fall and if demand exceeds supply, this currency will increase.
Extreme short-term movements can lead to the intervention of central banks, even in a variable rate environment. For this reason, while most of the world’s major currencies are considered floating, central banks and governments can intervene if a country’s currency becomes too high or too low.
Too high or too low a currency could negatively affect the country’s economy, affecting trade and the ability to pay debts. The government or the central bank will try to implement measures to move their currency towards a more favorable price.
Floating exchange rates versus fixed rates
Currency prices can be determined in two ways: a variable rate or a fixed rate. As mentioned above, the variable rate is generally determined by the free market through supply and demand. Therefore, if the demand for money is high, the value will increase. If demand is weak, it will lower the price of that currency.
A fixed or indexed rate is determined by the government through its central bank. The rate is set against another major global currency (such as the US dollar, the euro or the yen). To maintain its exchange rate, the government will buy and sell its own currency against the currency to which it is pegged. Some countries that choose to peg their currencies to the U.S. dollar include China and Saudi Arabia.
The currencies of most of the world’s major economies were allowed to float freely after the collapse of the Bretton Woods system between 1968 and 1973.
History of floating exchange rates via the Bretton Woods agreement
The Bretton Woods Conference, which established a gold standard for currency, took place in July 1944. A total of 44 countries came together, with participants limited to the Allies during the Second World War. The Conference created the International Monetary Fund (IMF) and the World Bank, and defined the guidelines for a fixed exchange rate system. The system established a gold price of $ 35 per ounce, with participating countries arriving at their dollar dollars. Adjustments of plus or minus one percent were allowed. The US dollar became the reserve currency through which central banks intervened to adjust or stabilize rates.
The first major crack in the system appeared in 1967, with a gold rush and an attack on the pound sterling which led to a devaluation of 14.3%. President Richard Nixon removed the United States from the gold standard in 1971.
By the end of 1973, the system had collapsed and participating currencies were allowed to float freely.
Failed to attempt intervention in a currency
In floating exchange rate systems, central banks buy or sell their local currencies to adjust the exchange rate. This can be aimed at stabilizing a volatile market or achieving a major rate change. Groups of central banks, such as those in the G-7 countries (Canada, France, Germany, Italy, Japan, the United Kingdom and the United States), often work together in coordinated interventions to increase impact.
An intervention is often short-lived and does not always succeed. A vivid example of a failed intervention took place in 1992 when financier George Soros led an attack on the pound sterling. The currency entered the European Exchange Mechanism (ERM) in October 1990; the ERM was designed to limit currency volatility as a source of entry into the euro, which was still in the planning stages. Soros believed that the pound had entered at an excessively high rate and he launched a concerted attack on the currency. The Bank of England was forced to devalue the currency and withdraw from the ERM. The failed intervention cost the British Treasury £ 3.3 billion. Soros, on the other hand, has grossed over a billion dollars.
Central banks can also intervene indirectly in the currency markets by raising or lowering interest rates to influence the flow of funds to investors in the country. Since attempts to control prices in narrow bands have failed in the past, many countries choose to float their currency freely and then use economic tools to help push it one way or the other. if it goes too far for their comfort.