Floating Exchange Rate Definition
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.
A Little More on Whatt is Floating Exchange Rate
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.
References for Floating Exchange Rates
Academic Research on Floating Exchange Rate
Domestic financial policies under fixed and under floating exchange rates, Fleming, J. M. (1962). Staff Papers, 9(3), 369-380. This article shows that the expansion resulting from a given increase in money supply will always be stronger if the country has a fluctuating exchange rate than if it has a fixed rate.
Mirage of floating exchange rates, Reinhart, C. M. (2000). American Economic Review, 90(2), 65-70. This note summarizes some of the highlights of the author’s longer paper with Guillermo Calvo”Fear of Floating.” It analyses the behavior of exchange rates, reserves, and interest rates to assess whether there is evidence that country practice is moving toward corner solutions. The paper focuses on whether countries that claim they are floating are indeed doing so. Findings are that countries that say they allow their exchange rate to float mostly do not–there seems to be an epidemic case of “fear of floating.”
Mexico’s monetary policy framework under a floating exchange rate regime, Carstens, A. G., & Werner, A. M. (2000). Inflation Targeting in Practice: Strategic and Operational Issues and Application to Emerging Market Economies, 80. This paper provides an overview of the transition towards the floating exchange rate regime, the functioning of the floating exchannge system in Mexico, the current monetary policy framework and the behavior of the Mexican economy in recent years.
Was it real? The exchange rate‐interest differential relation over the modern floating‐rate period, Meese, R., & Rogofp, K. (1988). the Journal of Finance, 43(4), 933-948. This literature explores the relationship between real exchange rates and real interest rate differentials in the United States, Germany, Japan, and the United Kingdom. Contrary to theories based on the joint hypothesis that domestic prices are sticky and monetary disturbances are predominant, there is little evidence of a stable relationship between real interest rates and real exchange rates.
The exchange rate, the balance of payments and monetary and fiscal policy under a regime of controlled floating, Mussa, M. (1976). The Scandinavian Journal of Economics, 229-248. This paper considers the extension of the fundamental principles of the monetary approach to balance of payments analysis to a regime of floating exchange rates, with active intervention by the authorities to control rate movements.
Some new stylized facts of floating exchange rates, Lothian, J. R. (1998). Journal of International Money and Finance, 17(1), 29-39. This paper re-examines real exchange rate behavior of OECD currencies under the current float using the more extensive dataset that an additional decade’s worth of experience has made available.
Dynamics of a floating exchange rate regime, Helpman, E., & Razin, A. (1982). Journal of political Economy, 90(4), 728-754. This study investigates the full equilibrium dynamics of a two-country world economy with a floating exchange rate, traded and nontraded goods, and explicit modeling of the use of money.
Intervention and sterilisation under floating exchange rates: The UK 1973–1983, Kearney, C., & MacDonald, R. (1986). European Economic Review, 30(2), 345-364. In this paper a small portfolio balance model, in the spirit of Obstfeld (1983), is estimated for the sterling pound-US dollar exchange rate, over the period 1973 quarter 2 to 1983 quarter 4. It is demonstrated inter alia, that pure, or sterilised, foreign exchange market intervention can be effective, even when agents form expectations rationally.