Floating Exchange Rate – Explained for Dummies

Exchange rate explained

An exchange rate is the price of one country’s currency in terms of another currency. Put differently, it indicates how many units of your country’s currency are required to buy one unit of a foreign currency.

An exchange rate is not only applicable to a particular country, but also to certain economic and political regions, such as the European Union that utilizes the euro as currency for its member states.

Factors that influence a country’s exchange rate are, among others:

• Interest rates.
• Its trade balance.
• Political stability or instability.
• Inflation rate.
• The general state of the economy.

Basically, there are two types of exchange rates – fixed exchange rates and floating exchange rates.

Fixed exchange rate

A fixed exchange rate, also referred to as a pegged exchange rate, is an exchange rate that is pegged by a country’s monetary authority (e.g. central bank) to some commonly used currency or commodity, such as gold.

A currency that uses a fixed exchange rate is called a fixed currency.

Nowadays, most fixed exchange rates are tied to the US dollar. Countries such as Cuba, Lebanon, and Panama are countries that have their currencies tied to the US dollar. Countries in the Middle East like Saudi Arabia and the United Arab Emirates peg their currencies to the US dollar because the USA is a major trading partner for their oil.

However, some countries also tie their currencies to the currencies of their most frequent trading partners.

Some advantages of a fixed exchange rate

• It keeps a country’s currency value within a narrow band, avoiding extreme fluctuations.
• A fixed exchange rate always enables you to determine how much of one currency can be exchanged for another currency.
• It provides currency stability that could encourage foreign investments because investors always know the currency’s value. This could lead to lower inflation rates.

Some disadvantages of fixed exchange rates

• To maintain a fixed exchange rate can be expensive. A country with a pegged exchange rate must have enough foreign currency reserves to manage the value of its currency.
• A tied exchange rate can make a country’s currency vulnerable to speculators. They can artificially push the currency’s value down through shorting the currency.

Floating exchange rate

A floating exchange rate, also known as a fluctuating or flexible exchange rate, is a type of exchange rate system in which the value of a country’s currency is determined by the foreign exchange market (forex).

In a floating exchange system, the prices of currencies are driven by speculation and the law of supply and demand. Increased supply and lower demand cause the price of a currency to fall, while increased demand and lower supply imply that the price of a currency will increase.

A currency that has a floating exchange rate is referred to as a floating currency.

Floating exchange rates continuously fluctuate. Changing factors such as inflation, interest rates, political stability, trade balances, and speculation, to name but a few, influence the continued up and down movement of a floating currency’s price.

Normally, governments and monetary authorities (central banks) of countries allow floating exchange rates to be determined by market forces and there is no endeavour to regulate an exchange rate.

However, a country’s central bank often participates in the currency market to try and influence the value of its floating currency. This strategy is followed in order to keep the currency at a favourable level for international trade.

Governments or central banks can intervene in the forex market to adjust their floating exchange rates by means of buying or selling their local currencies. This can be done in order to stabilise a volatile market.

Intervention can also be managed indirectly by raising or lowering interest rates to affect the flow of investors’ funds into a country.

Although, interventions are often short-term solutions and are not always successful.

What is a clean float and a dirty float?

A clean float, also referred to as a pure exchange rate refers to a situation in which an exchange rate, or the value of a currency, is determined exclusively by the market forces of supply and demand, without any interference by a government.

Contrarily, a dirty float, also called a managed float, occurs when a floating currency is not dictated completely by demand and supply. It is partially controlled by government intervention, limiting the appreciation or depreciation of a currency within a specific range.

Countries with floating currencies

All of the following most traded currencies in the world are floating currencies (in alphabetical order): The Australian dollar (AUD), the British pound (GBP), the Canadian dollar (CAD), the euro (EUR), the Japanese yen (JPY), the New Zealand dollar (NZD), the Swiss franc (CHF), and the U.S. dollar (USD), commonly called the greenback.

The South African rand (ZAR) is also subject to a floating exchange rate.

When did floating exchange rates start?

In July 1944, the Bretton Woods Conference, officially known as the United Nations Monetary and Financial Conference, was held in New Hampshire in the U.S.A. The purpose was ‘to agree upon a series of new rules for the post-WWII international monetary system’, according to the archive section of the website of the U.S. Department of State.

The Conference established the International Monetary Fund (IMF) and the World Bank. It also formulated guidelines for a fixed exchange rate system. This system was in place for almost twenty-five years until the collapsing IMF system was replaced by floating exchange rates in the early 1970s.

Advantages of floating exchange rates

• A floating exchange rate is a better indicator of the true value of a currency based on supply and demand.
• No need for frequent intervention from a country’s central bank.
• More insulation from other countries’ macroeconomic problems, such as inflation or political instability.
• It reduces the negative impact of any external shocks, for instance, a floating exchange rate can change in response to a global shock, such as a rising oil price.
• A flexible exchange rate can depreciate to rectify the balance of payment deficits. This will help to restore the competitiveness of a country’s exports.

Disadvantages of a floating exchange rate

• Floating exchange rates make currencies potentially more volatile due to the unpredictability of the market and other factors.
• Propensity to aggravate existing problems: Prevailing macroeconomic problems such as high inflation or a high unemployment rate, may be worsened by a floating currency. For example, a high inflation rate may be pushed higher by a depreciating currency because of an increased demand for goods.
• Speculation can cause exchange rate changes that are unrelated to underlying trade patterns. This will lead to instability and uncertainty for businesses and individuals.

Frequently Asked Questions

Which countries have a floating exchange rate?

Apart from China, there are 65 more countries that have adopted the floating exchange rate, including Japan, USA and many of the European countries.

What is the meaning of floating exchange rate?

You will find our  Floating exchange Rate explained for Dummies very helpful.

Does the UK have a floating exchange rate?

Yes, it has had a floating exchange rate since 1972 except for two years.

Can governments influence a countries floating exchange rate?

Yes, governments sometimes intervene so that the currency does not float in a pure ‘clean’ market.

Does the economic state of a country influence the floating exchange rate?

Yes, it does.