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In macroeconomics and economic policy, a floating exchange rate (also known as a fluctuating or flexible exchange rate) is a type of exchange rate regime in which a
currency A currency, "in circulation", from la, currens, -entis, literally meaning "running" or "traversing" is a standardization of money in any form, in use or circulation as a medium of exchange, for example banknotes and coins. A more general ...
's value is allowed to fluctuate in response to
foreign exchange market The foreign exchange market (Forex, FX, or currency market) is a global decentralized or over-the-counter (OTC) market for the trading of currencies. This market determines foreign exchange rates for every currency. It includes all as ...
events. A currency that uses a floating exchange rate is known as a ''floating currency'', in contrast to a ''
fixed currency A fixed exchange rate, often called a pegged exchange rate, is a type of exchange rate regime in which a currency's value is fixed or pegged by a monetary authority against the value of another currency, a basket of other currencies, or another ...
'', the value of which is instead specified in terms of material
goods In economics, goods are items that satisfy human wants and provide utility, for example, to a consumer making a purchase of a satisfying product. A common distinction is made between goods which are transferable, and services, which are not ...
, another currency, or a set of currencies (the idea of the last being to reduce currency fluctuations). In the modern world, most of the world's currencies are floating, and include the most widely traded currencies: the
United States dollar The United States dollar ( symbol: $; code: USD; also abbreviated US$ or U.S. Dollar, to distinguish it from other dollar-denominated currencies; referred to as the dollar, U.S. dollar, American dollar, or colloquially buck) is the officia ...
, the
euro The euro ( symbol: €; code: EUR) is the official currency of 19 out of the member states of the European Union (EU). This group of states is known as the eurozone or, officially, the euro area, and includes about 340 million citizens . ...
, the
Swiss franc The Swiss franc is the currency and legal tender of Switzerland and Liechtenstein. It is also legal tender in the Italian exclave of Campione d'Italia which is surrounded by Swiss territory. The Swiss National Bank (SNB) issues banknotes and the ...
, the
Indian rupee The Indian rupee ( symbol: ₹; code: INR) is the official currency in the republic of India. The rupee is subdivided into 100 '' paise'' (singular: ''paisa''), though as of 2022, coins of denomination of 1 rupee are the lowest value in use ...
, the
pound sterling Sterling (abbreviation: stg; Other spelling styles, such as STG and Stg, are also seen. ISO code: GBP) is the currency of the United Kingdom and nine of its associated territories. The pound ( sign: £) is the main unit of sterling, and ...
, the
Japanese yen The is the official currency of Japan. It is the third-most traded currency in the foreign exchange market, after the United States dollar (US$) and the euro. It is also widely used as a third reserve currency after the US dollar and the ...
, and the
Australian dollar The Australian dollar ( sign: $; code: AUD) is the currency of Australia, including its external territories: Christmas Island, Cocos (Keeling) Islands, and Norfolk Island. It is officially used as currency by three independent Pacific Is ...
. However, even with floating currencies,
central bank A central bank, reserve bank, or monetary authority is an institution that manages the currency and monetary policy of a country or monetary union, and oversees their commercial banking system. In contrast to a commercial bank, a centra ...
s often participate in markets to attempt to influence the value of floating exchange rates. The Canadian dollar most closely resembles a pure floating currency because the Canadian national bank has not interfered with its price since it officially stopped doing so during 1998. The US dollar is a close second, with very little change of its foreign reserves. By contrast, Japan and the UK intervene to a greater extent, and India has medium-range intervention by its national bank, the
Reserve Bank of India The Reserve Bank of India, chiefly known as RBI, is India's central bank and regulatory body responsible for regulation of the Indian banking system. It is under the ownership of Ministry of Finance, Government of India. It is responsible f ...
. From 1946 to the early 1970s, the
Bretton Woods system The Bretton Woods system of monetary management established the rules for commercial and financial relations among the United States, Canada, Western European countries, Australia, and Japan after the 1944 Bretton Woods Agreement. The Bretto ...
made fixed currencies the norm; however, during 1971, the US government decided to discontinue maintaining the dollar exchange at 1/35 of an ounce of gold and so its currency was no longer fixed. After the end of the
Smithsonian Agreement The Smithsonian Agreement, announced in December 1971, created a new dollar standard, whereby the currencies of a number of industrialized states were pegged to the US dollar. These currencies were allowed to fluctuate by 2.25% against the dol ...
in 1973, most of the world's currencies followed suit. However, some countries, such as most of the Arab states of the Persian Gulf region, fixed their currency to the value of another currency, which has been associated more recently with slower rates of growth. When a currency floats, quantities other than the exchange rate itself are used to administer
monetary policy Monetary policy is the policy adopted by the monetary authority of a nation to control either the interest rate payable for federal funds, very short-term borrowing (borrowing by banks from each other to meet their short-term needs) or the money s ...
(see
open-market operation In macroeconomics, an open market operation (OMO) is an activity by a central bank to give (or take) liquidity in its currency to (or from) a bank or a group of banks. The central bank can either buy or sell government bonds (or other financial as ...
s).


Economic rationale

Some economists believe that in most circumstances, floating exchange rates are preferable to fixed exchange rates. As floating exchange rates adjust automatically, they enable a country to dampen the effect of shocks and foreign business cycles and to preempt the possibility of having a
balance of payments crisis A currency crisis is a type of financial crisis, and is often associated with a real economic crisis. A currency crisis raises the probability of a banking crisis or a default crisis. During a currency crisis the value of foreign denominated de ...
. However, they also engender unpredictability as the result of their variability, which can render businesses' planning risky since the future exchange rates during their planning periods are uncertain. However, in certain situations, fixed exchange rates may be preferable for their greater stability and certainty. That 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
1997 Asian financial crisis The Asian financial crisis was a period of financial crisis that gripped much of East Asia and Southeast Asia beginning in July 1997 and raised fears of a worldwide economic meltdown due to financial contagion. However, the recovery in 1998– ...
. The debate of choosing between fixed and floating exchange rate methods is formalized by the Mundell–Fleming model, which argues that an economy (or the government) cannot simultaneously maintain a fixed exchange rate, free capital movement, and an independent monetary policy. It must choose any two for control and leave the other to market forces. The primary argument for a floating exchange rate is that it allows monetary policies to be useful for other purposes. Using fixed rates, monetary policy is committed to the single goal of maintaining the exchange rate at its announced level. However, the exchange rate is only one of the many macroeconomic variables that monetary policy can influence. A system of floating exchange rates leaves monetary policymakers free to pursue other goals, such as stabilizing employment or prices. During an extreme appreciation or
depreciation In accountancy, depreciation is a term that refers to two aspects of the same concept: first, the actual decrease of fair value of an asset, such as the decrease in value of factory equipment each year as it is used and wear, and second, the ...
of currency, a
central bank A central bank, reserve bank, or monetary authority is an institution that manages the currency and monetary policy of a country or monetary union, and oversees their commercial banking system. In contrast to a commercial bank, a centra ...
will normally intervene to stabilize the currency. Thus, the exchange rate methods of floating currencies may more technically be known as managed float. A national bank might, for instance, allow a currency price to float freely between an upper and lower bound, a price "ceiling" and "floor". Management by a national 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.


Aversion to floating

A free floating exchange rate increases foreign exchange volatility. Some economists believe that this could cause serious problems, especially in developing economies. Those 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. Therefore, developing countries seem to have greater aversion to floating, as they have much smaller variations of the nominal exchange rate but experience greater shocks and interest rate and reserve changes. This is the consequence of frequent free floating countries' reaction to exchange rate changes with
monetary policy Monetary policy is the policy adopted by the monetary authority of a nation to control either the interest rate payable for federal funds, very short-term borrowing (borrowing by banks from each other to meet their short-term needs) or the money s ...
and/or intervention in the foreign exchange market. The number of countries that show aversion to floating increased significantly during the 1990s.


See also

* Domestic liability dollarization * List of countries with floating currencies *
Currency appreciation and depreciation Currency depreciation is the loss of value of a country's currency with respect to one or more foreign reference currencies, typically in a floating exchange rate system in which no official currency value is maintained. Currency appreciatio ...


References


Further reading


Exchange rate and fiscal performance. Do fixed exchange rate regimes generate more discipline than flexible ones?
Vúletin, Guillermo Javier. April 2002. {{DEFAULTSORT:Floating Exchange Rate Foreign exchange market