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''De facto'' exchange-rate arrangements in 2013 as classified by the International Monetary Fund. In
macroeconomics Macroeconomics (from the Greek prefix ''makro-'' meaning "large" + ''economics'') is a branch of economics Economics () is the social science that studies how people interact with value; in particular, the Production (economics), producti ...
and
economic policy The economic policy of governments covers the systems for setting levels of taxation, government budgets, the money supply and interest rates as well as the labour market, nationalization, national ownership, and many other areas of government ...
, a floating exchange rate (also known as a fluctuating or flexible exchange rate) is a type of
exchange rate regime An exchange rate regime is the way a monetary authority of a country or currency union manages the currency in relation to other currencies and the foreign exchange market The foreign exchange market (Forex, FX, or currency market) is a glo ...
in which a currency's value is allowed to fluctuate in response to
foreign exchange market The foreign exchange market (Forex, FX, or currency market) is a global decentralization, decentralized or Over-the-counter (finance), over-the-counter (OTC) market for the trading of currency, currencies. This market determines Exchange rate ...
events. A currency that uses a floating exchange rate is known as a ''floating currency'', in contrast to a '' fixed currency'', the value of which is instead specified in terms of material goods, 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 (Currency symbol, symbol: ; ISO 4217, 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 colloquial b ...
, the
euro The euro (currency symbol, symbol: euro sign, €; ISO 4217, code: EUR) is the official currency of 19 of the Member state of the European Union, member states of the European Union. This group of states is known as the eurozone or euro area ...
, the Swiss franc, the Indian rupee, the pound sterling, the Japanese yen, 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 Island ...
. 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 State (polity), state or formal monetary union, and oversees their commercial bank, commercial banking system. In contras ...
s often participate in markets to attempt to influence the value of floating exchange rates. The
Canadian dollar The Canadian dollar (symbol A symbol is a mark, sign, or word that indicates, signifies, or is understood as representing an idea, Object (philosophy), object, or wikt:relationship, relationship. Symbols allow people to go beyond what is ...
most closely resembles a pure floating currency because the
Canadian national bank
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. From 1946 to the early 1970s, the Bretton Woods system 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 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 (see open-market operations).


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 shock (economics), shocks and foreign business cycles and to preempt the possibility of having a currency crisis, balance of payments crisis. 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 Asian currency crisis, 1997 Asian financial crisis. 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 (currency), appreciation or depreciation (currency), depreciation 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 State (polity), state or formal monetary union, and oversees their commercial bank, commercial banking system. In contras ...
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 Liability (financial accounting), 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 and/or currency intervention, 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


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