Floating Exchange Rate

A floating exchange rate is an exchange rate system where a country’s currency price is determined by the foreign exchange market, depending on the relative supply and demand of other currencies. A floating exchange rate is not restrained by trade limits or government controls, unlike a fixed exchange rate.

A floating exchange rate refers to an exchange rate system where a country’s currency price is determined by the relative supply and demand of other currencies.

Currencies with floating exchange rates can be traded without any restrictions, unlike currencies with fixed exchange rates.

Although the floating exchange rate is not entirely determined by the government and central banks, they can intervene to keep the currency at a favorable price for global trade.

A floating exchange rate functions in an open market where speculations, along with demand and supply forces, drive the price. Floating exchange rate structures mean that changes in long-term currency prices represent comparative economic strength and differences in interest rates across countries. Changes in the short-term floating exchange rate represent disasters, speculations, and the daily supply and demand of the currency.

In the graph below, an increased currency supply from S1 to S2 at the same demand D1 implies that the currency-pair price will depreciate. In contrast, increased demand from D1 to D2 at the same supply S1 will lead to currency appreciation.

Market sentiment towards the economy of a country affects how strong or weak the floating currency is perceived. For example, a country’s currency is expected to depreciate if the market views the government as unstable. Although the floating exchange rate is not entirely determined by the government, they can intervene when the currency is too low or too high to keep the currency at a favorable price.

A balance of payments is in the statement of transactions between entities of a country and the entities of the rest of the world over a time period. In theory, any imbalance in that statement automatically changes the exchange rate.

For example, if the imbalance is a deficit, it would cause the currency to depreciate. The country’s exports would become cheaper, resulting in an increase in demand and eventually attaining equilibrium in the BOP.

Investopedia