Floating Exchange Rate

A floating exchange rate is a regime where the currency price of a nation is set by the forex market based on supply and demand relative to other currencies. This is in contrast to a fixed exchange rate, in which the government entirely or predominantly determines the rate.

A floating exchange rate is one that is determined by supply and demand on the open market.

A floating exchange rate doesn’t mean countries don’t try to intervene and manipulate their currency’s price, since governments and central banks regularly attempt to keep their currency price favourable for international trade.

A fixed exchange is another currency model, and this is where a currency is pegged or held at the same value relative to another currency.

Floating exchange rates became more popular after the failure of the gold standard and the Bretton Woods agreement.

Floating exchange rate systems mean long-term currency price changes reflect relative economic strength and interest rate differentials between countries.

Short-term moves in a floating exchange rate currency reflect speculation, rumours, disasters, and everyday supply and demand for the currency. If supply outstrips demand that currency will fall, and if demand outstrips supply that currency will rise.

Extreme short-term moves can result in intervention by central banks, even in a floating rate environment. Because of this, while most major global currencies are considered floating, central banks and governments may step in if a nation’s currency becomes too high or too low.

A currency that is too high or too low could affect the nation’s economy negatively, affecting trade and the ability to pay debts. The government or central bank will attempt to implement measures to move their currency to a more favourable price.

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Currency prices can be determined in two ways: a floating rate or a fixed rate. As mentioned above, the floating rate is usually determined by the open market through supply and demand. Therefore, if the demand for the currency is high, the value will increase. If demand is low, this will drive that currency price lower.

A fixed or pegged rate is determined by the government through its central bank. The rate is set against another major world currency (such as the U.S. dollar, euro, or yen). To maintain its exchange rate, the government will buy and sell its own currency against the currency to which it is pegged. Some countries that choose to peg their currencies to the U.S. dollar include China and Saudi Arabia.

The currencies of most of the world’s major economies were allowed to float freely following the collapse of the Bretton Woods system between 1968 and 1973.

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