Floating Exchange Rate: Definition, Pros, Cons & Example
What is a Floating Exchange Rate
A floating exchange rate is where the value of a nation’s currency, when compared to another, is determined by supply and demand. There are millions of traders across the world who buy and sell currencies which helps dictate its value in relation to others.
The Floating Exchange Rate is determined by these daily interactions between traders. If traders are heavily selling the US dollar, it is likely to decrease in value against other currencies. This means that more dollars will be needed to buy the same number of goods from abroad.
- The floating exchange rate is determined by supply and demand on the foreign exchange market.
- It is in contrast to the fixed exchange rate system which relies on central banks to maintain a set rate against a ‘pegged’ currency – usually the Euro or the US dollar.
- The floating exchange rate came around after the collapse of the Bretton Wood agreement which fixed the US dollar to gold.
How a Floating Exchange Rate Works
The basis of a floating exchange rate system is that of supply and demand. If supply is greater than demand, the currency’s value will decline. By contrast, if the demand is greater than supply, then its value will increase.
In the short-term, the floating exchange rate can be influenced by factors such as speculation, natural disasters, and political news. For instance, an election can often lead to periods of negative sentiment if an extremist party have a chance of clinching power.
In the long-term however, the floating exchange rate tends to fluctuate based on the nation’s economic performance and its balance of trade. If an economy is doing badly, it tends to see less investment from abroad. That means less currency is being demanded, therefore putting a negative pressure on its value.
The balance of trade is the net of what a country exports and imports. So if a country imports more than it exports, it has a net outflow of its currency. This is because it is demanding more goods from other nations, than those nations are demanding from it domestically. In turn, the nation is sending more of its currency abroad, thereby increasing its supply onto the market and decreasing its value.
In theory, the floating exchange rate mechanism can help countries to recover from recession. This is because its currency will tend to weaken as a result of poor economic performance. In turn, exports become more competitive because they are cheaper on the international market. This can help provide a boost for domestic exporters. At the same time, imports become more expensive. This might make goods more expensive in the short-term, but has the potential to boost alternative domestic suppliers which become comparatively cheaper.
History of Floating Exchange Rate
In 1944, in the midst of World War II, 44 of the allied nations convened in Bretton Woods, New Hampshire (USA). The aim was to set up a new economic system that would create stability across the global economy following the ravages of war.
In turn, the allied nations set up the International Monetary Fund (IMF) and the World Bank. The nations also agreed upon a fixed exchange rate which was indirectly linked to gold.
As part of the agreement, the price of gold would be set at $35 per ounce. Those countries participating in the agreement would then peg their currency to the US dollar. This meant that 1 US dollar would be equal to 1 Great British Pound or other currency.
As a result of the agreement, the US dollar essentially became a reserve currency for nations across the world. Nations would have comfort in knowing that it could convert its domestic currency to dollars and then those dollars into gold.
“After Bretton Woods, the US dollar become the reserve currency for nations across the world.”
This system had relative success and lasted over 30 years without much issue. However, the wheels started to come off in the 1960s during the presidencies of John F Kennedy and Lyndon B Johnson. The US was heavily funding the Vietnam war, whilst also undertaking Johnson’s ‘Great Society’ policy. Both of which led to high fiscal deficits – deficits which were paid for by printing more money alongside higher government debt.
Essentially, the US dollar was losing its value, but because it was pegged to other currencies, it was artificially maintained. In turn, other currencies such as the Japanese Yen and German Deutsche Mark were undervalued. This meant that there was far more dollars circulating than there was gold to cover its possible redemption.
The US dollar was seen as overvalued due to inflation and an expansionary fiscal policy adopted by American Presidents. This caused a run-on gold and pressure on the US dollar. International markets started to realise that the supply of the US dollar far exceeded that of gold. In turn, these pressures caused US President, Richard Nixon to devalue the gold conversion rate from $35 an ounce to $38 an ounce.
By the summer of 1971, speculators were moving funds out of dollars and into foreign currencies, and central banks were rapidly converting dollars into U.S. gold.
This led to Nixon taking the US off the gold standard, meaning nations could no longer convert US dollars for gold. This led to gold rising to $90 an ounce by early 1973 – later leading to the collapse of the Bretton Woods agreement.
Floating Exchange Rates took the place of the fixed rate exchange system created at Bretton Woods. Nations would be able to freely let markets dictate the price of currencies and their value against others.
Advantages of Floating Exchange Rate
1. Stability in Balance of Trade
The balance of trade is the difference between what a country imports and what it exports. It may also be known as ‘net imports’. This is an important economic aspect as it is one component of a nation’s economic output.
The floating exchange rate allows greater stability in this area as the currency is able to fluctuate. When the value of a currency decreases, it means that exports become cheaper to the rest of the world. That provides a boost to the nations balance of trade as it can export more because it is comparatively cheaper than its competitors.
By contrast, when a nation is selling a high number of goods abroad and has a positive balance of trade, its currency is likely to strengthen. That means other countries will start to find it more expensive to import from that country. In turn, nations may look elsewhere for cheaper goods which places a negative impact on the exchange rate.
2. Inflation Stability
One of the main drawbacks of a fixed exchange rate was that countries would naturally ‘import’ higher prices. For example, inflation may occur in the US which increases the price of motor vehicles from $10,000 to $12,000. That’s a 20 percent rise. However, this increase is not reflected in the exchange rate which is fixed at 1:1. So someone in the UK would go from paying £10,000 for a motor vehicle, to £12,000 – because the exchange rate is fixed at 1 US Dollar to 1 Great British Pound.
The benefit of a free floating exchange rate is that countries with excessive inflation will see a decline in the value of its currency. This will then help to balance out the inflationary impact on other countries.
3. Lower Foreign Exchange Reserves
By operating under a floating exchange rate system, a nation’s central bank no longer needs large reserve currencies to fix the exchange rate. Under a fixed exchange rate system, central banks would need a large range of currencies. This is so that if it needed to strengthen its currency, it would sell foreign reserves – thereby increasing others supply to the market and decreasing the value.
Instead, under a floating exchange rate system, those same funds could be used in a way that benefits the wider economy.
Under a fixed rate system, centrals banks of different nations must work in line with each other. For example, if one nation increases its interest rates to deal with inflation, other central banks will need to react. This is because what happens in one nation is likely to affect the monetary conditions in another.
When currencies are pegged to the dollar, any changes to its value will have an impact on its value. In turn, these nations are at the whim of the US Federal Reserve and its monetary policy. By contrast, a free floating exchange rate allows nations to decide on their own monetary policy without solely focusing on other nations.
5. Fewer Speculative Attacks
When a currency is artificially forced to remain at a static level, there is often a bubbling up of market activity. Investors know that the currency is widely undervalued, but under a fixed exchange rate, central banks struggle to maintain the pegged rate.
There comes a point whereby a nations currency remains stagnant, but the fundamentals show that it is highly under or overvalued. This opens the door to speculative attacks on a currency as they seek to make some easy money. In turn, this can lead to dramatic shifts in the foreign exchange market which can cause great distress to national economies.
By contrast, a floating exchange rate changes constantly reflecting a large array of fundamental conditions ranging from inflation to economic performance. Therefore the exchange rate is largely in line with its underlying value.
Disadvantages of Floating Exchange Rate
1. Worsening of Economic Issues
Nations may be facing economic hardship at home. This might be excessive rates of inflation, economic stagnation, or poor employment opportunities. All of which can play a part in the foreign exchange market.
As a result of the floating exchange rate, investors look at fundamental attributes of an economy to determine its value. Such fundamentals include economic indicators such as growth and inflation. So when these values are performing poorly, it’s likely to lose value versus other currencies.
This has the potential to further push the economy down as a weakened currency puts pricing pressures on its imports. So for nations that heavily import, it may face higher prices which is likely to reduce consumer demand.
2. Potential Volatility
One of the main issues with a free floating exchange rate is that it can create volatile conditions for businesses and nations. A sharp decline in the value of one currency may significantly affect the dynamics of its economy. Imports become significantly more expensive, which puts pressure on value adding exporters. Furthermore, those businesses that import raw materials will see higher prices as a result.
If the economy is shaped in a way by which imports is a key component, it may face more hardship during periods of weak currency. By contrast, nations like China, that are export led, may benefit. Because most of its business is focused on exporting, its goods become cheaper abroad, thereby increasing demand and improving economic conditions at home.
3. Poor Monetary Policy
The floating exchange rate absolves the central bank of responsibility to keep its currency pegged. Instead, it has autonomy to pursue its monetary policy and economic agenda.
This is a double-sided coin. On the one hand, a well-managed monetary system can benefit from this freedom. On the other hand, a poorly-managed one can result in hyper-inflation and a financial crisis.
Many countries have tried to print their way out of debt, but the result has always been excessive levels of inflation and a bad credit rating. Instead, nations that might struggle to manage its monetary policy are best having a fixed exchange rate. For instance, it may be prone to reducing interest rates or increasing the supply of money. This might be political, or through corruption. So by having its rate pegged, it is more difficult for subsequent officials to manipulate the currency.
Difference between Fixed and Floating Exchange Rate
The two main types of exchange rate systems come in either fixed or floating. The main difference is that the floating exchange rate is determined by supply and demand via an open market. By contrast, central banks look to keep a fixed currency at the set rate, otherwise known as ‘pegged’ to another, usually the US dollar.
When a nation uses a fixed exchange rate, its central banks does one of two things. It either sells its own currency against its pegged alternative. Or, it uses its foreign exchange reserves and sells these to buy its own domestic currency. This then keeps the rate pegged to the agreed level. Some nations that peg to the US dollar include: Saudi Arabia, South Sudan, and Panama, among others.
Floating Exchange Rate Example
The floating exchange rate is dictated by supply and demand. So when demand for the US dollar increases, so too does its ‘strength’ or value. This means that those with US dollars are able to buy more goods from other countries.
By contrast, when demand for the US dollar decreases, so does its ‘strength’. As the currency weakens, those with US dollars will be unable to buy as many goods or services from other nations.
For example, in May 2021, the US dollar was valued at 0.82 Euros to the US Dollar. It subsequently rose to 0.96 to the Dollar a year later in May 2022.
The reason for such was that the demand for the US dollar was increasing. Why? Well there are many factors which led investors to the US. The most prominent is the tightening on monetary policy. The Federal Reserve has been more courageous with increasing interest rates and pulling back on its bond purchasing program. This is something other nations have been more reluctant to do, but represents investors with better opportunities in the US.
Among other factors include the nations strong economic comeback after COVID. Growth is comparatively strong and unemployment rates were at record lows. Such fundamentals have helped increase the demand of the US dollar versus other currencies which are not so favourable.
Some of the advantages of a floating exchange rate include:
1. Stability in Balance of Trade
2. Inflation Stability
3. Lower Foreign Exchange Reserves
5. Fewer Speculative Attacks
The US has a floating exchange rate and has done since the collapse of the Bretton Wood agreement which fixed the US dollar to gold.
Most developed nations have floating exchange rates, including the US, the UK, France, Germany, Italy, and Spain, among others. By contrast, a large part of Africa has a fixed rate system against either the Euro or the US dollar. This is partially due to help avoid corrupt regimes using its currency to their own political advantage.
Paul Boyce is an economics editor with over 10 years experience in the industry. Currently working as a consultant within the financial services sector, Paul is the CEO and chief editor of BoyceWire. He has written publications for FEE, the Mises Institute, and many others.