What is a Floating Exchange Rate?

A Floating Exchange Rate system is when the foreign currency exchange (forex) market sets the currency price on the basis of supply and demand of other currencies. This is opposite to the fixed exchange rate wherein the government fully determines the exchange rate.

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How Does a Floating Exchange Rate Work?

Currency prices are based on either a floating rate or fixed rate. The floating rate is generally decided by the private market via supply and demand. So, if there is a high demand for currency, the rate increases. A major economic impact of a strong currency is that it makes imports cheaper for the country. Floating exchange rates are highly affected by disparities in economic strength and differences in interest rate between countries. Also, short-term rate swings result from speculation by investors, natural or man-made disasters, and rumors. Severe short-term swings in exchange rates leads to central bank intervention, irrespective of whether there is a floating rate economy. In the floating exchange rate systems, central banks trade their local currencies for exchange rate adjustments. This stabilizes an otherwise unstable market or achieves the desired change in the exchange rate. Central banks, like G-7 nations (Canada, Germany, France, Italy, the United Kingdom, Japan, and the United States), collaborate for interventions to have maximum impact. In contrast, a fixed exchange rate (also called pegged rate) is decided by the central bank. The rate is generally pegged to key currencies like the U.S. dollar, YEN or Euro. To stabilize its exchange rate, the government trades its currency with the currency to to which it is based (pegged) on the forex market. In actuality, currencies are seldom solely fixed or floating, as market pressures affect exchange rates.

Floating Exchange Rates and the Bretton Woods Agreement

The Bretton Woods Conference was in held in July 1944, and was attended by 44 countries (the Allies in World War II). This led to formation of the International Monetary Fund (IMF) and the World Bank. It also resulted in a regulated fixed exchange rate system. It put a gold prices at $35 per ounce, with attending countries fixing their currency to US dollar. 1 percent adjustments were permitted. The U.S. dollar turned out to be the reserve currency, as central banks made intervention through it to stabilize or change rates. After the fall of Bretton Woods system between 1968 and 1973, most of the major currencies floated freely.