What is the Floating Exchange Rate?

Explanation

A floating exchange rate is the relative value of one currency concerning another country’s currency, driven by the speculation and supply and demand forces prevailing in the market. For example, in the below-mentioned diagram, when there is an increase in the pound’s demand, the pound to dollar increases from 1 Pound = Dollar 1.45 to 1 Pound = Dollar 1.55. That is how the floating rate changes concerning the demand and supply factors. 

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How Does it Work?

In the case of the floating exchange rate system, when the currency’s demand is low, its value decreases, but at the same time, due to this, imported goods will become more expensive for the people holding the currency. With this, people will usually stop importing the goods and start buying domestic goods. As a result, more employment will be generated, thereby stimulating the economyEconomyAn economy comprises individuals, commercial entities, and the government involved in the production, distribution, exchange, and consumption of products and services in a society.read more. The vice versa of this also holds wherein the currency’s demand is more than its value increases. However, at the same time, due to this, imported goods will become cheaper for the people holding the currency. With this, people will usually start importing more goods. As a result, they would stop buying domestic goods. Subsequently, more unemployment will prevail in the economy and thereby cause a slowdown in the economy.

Example of Floating Exchange Rate

1 United States Dollar equals 0.78 Pound Sterling on a particular day. But a day before, the same was 0.76-Pound Sterling which might increase or decrease the next day based on the demand and supply forces prevailing in the market.

Managed Floating Exchange Rate

The private market determines it based on supply and demand in the open market. The managed floating currency rate is similar to the flexible currency rate system. But during heavy and frequent fluctuations in foreign exchange marketsForeign Exchange MarketsThe foreign exchange market is the world’s largest financial market that decides the exchange rate of currencies.read more, the Central Bank, under a managed floating exchange rate system, interferes in the foreign exchange market to purchase or sell the currencies to minimize the fluctuations and keep their currency price favorable for international tradeInternational TradeInternational Trade refers to the trading or exchange of goods and or services across international borders. read more.

Floating Exchange Rate vs Fixed Exchange Rate

The key difference between the two is as follows:

  • The fixed exchange rateFixed Exchange RateA fixed exchange rate refers to an exchange rate regime where a country’s currency value will be tied with the value of another country’s currency or a major commodity.read more is the standard rate set by a monetary authority concerning foreign currency. In comparison, the Forex market’s floating rate is determined by demand and supply and fluctuates constantly.The risk in the floating rate is more than a fixed rate.The favorable floating forex rate motivates investmentInvestmentInvestments are typically assets bought at present with the expectation of higher returns in the future. Its consumption is foregone now for benefits that investors can reap from it later.read more in the foreign market compared to the fixed forex rate.The fixed exchange rate is fixed at an officially set level. However, if the floating exchange rate fluctuates too much, the Central Bank intervenes to keep it near the formally established level.The private market determines the floating forex rate through supply and demand, whereas the government/ Central Bank determines the fixed exchange rate.

Impact

The impacts on different areas are discussed below:

#1 – Impact on Economy

Currency fluctuations have a direct impact on the monetary policy of the country Monetary Policy Of The CountryMonetary policy refers to the steps taken by a country’s central bank to control the money supply for economic stability. For example, policymakers manipulate money circulation for increasing employment, GDP, price stability by using tools such as interest rates, reserves, bonds, etc.read more. Constant currency fluctuations can adversely affect the market and foreign and local trade.

#2 – Impact on Consumer

Weak currency increases the cost of imports. Consequently, the charge is borne by consumers only. On the other hand, a stable currency allows consumers to buy more. The best example is oil prices in the international market due to its heavy fluctuations effect on price can be seen clearly.

#3 – Impact on Business

Currency fluctuations affect all kinds of business. But the most effective is on export or import business suppliers. Even if the company does not sell or purchase foreign currency directly, these fluctuations can be unseen.

Advantages

The advantages are as follows:

  • No Need for International Management of Exchange Rates: The exchange rate is determined by demand and supply in the market, and there is no government intervention until fluctuations are too high.No Need for Frequent Central Bank Intervention: The Central Bank frequently intervenes in fixed currency regimes. Whereas in floating currency, rate intervention is minimum or only when there are many fluctuations.Enhances Market Efficiency: The macroeconomics MacroeconomicMacroeconomics aims at studying aspects and phenomena important to the national economy and world economy at large like GDP, inflation, fiscal policies, monetary policies, unemployment rates.read more affects the exchange rate in international markets, which affects the share marketShare MarketThe share market is a public exchange where one can buy and sell company shares based on the demand and supply of shares. read more of nations, forcing governments to perform better and better.The benefit of Favourable Market Conditions to a Country: It is determined by demand and supply. Hence, its rate increases if market conditions are favorable to the country. Accordingly, the government gets the benefit of the same.

Disadvantages

The disadvantages are as follows:

  • Higher Volatility: They are highly volatile; hence, they affect the country’s trade policy and price directly or indirectly.Lack of Investment: Higher volatilityVolatilityVolatility is the rate of fluctuations in the trading price of securities for a specific return. It is the shift of asset prices between a higher value and a lower value over a specific trading period. read more in exchange rate increase the risk in financial marketsFinancial MarketsThe term “financial market” refers to the marketplace where activities such as the creation and trading of various financial assets such as bonds, stocks, commodities, currencies, and derivatives take place. It provides a platform for sellers and buyers to interact and trade at a price determined by market forces.read more Hence investors who afford to invest with limited risk would not afford to invest.Worsen Existing Problems: If the country faces problems like inflation, unemployment, or deficit in the balance of tradeBalance Of TradeThe balance of trade (BOT) is the country’s exports minus its imports. BOT is one of the significant components for any current economic asset as it measures a country’s net income earned on global investments.read more, floating exchange rates may worsen the conditions.

Conclusion

It is the rate determined based on supply and demand forces in the market. It fluctuates every day. But if fluctuations are too volatile, the Central Bank will intervene in the foreign exchangeForeign ExchangeForeign exchange, or Forex, is trading one currency for values equivalent to another currency.read more market to control the changes by buying or selling the currency. The Central Bank determines the fixed exchange rate. If a currency is favorable, the floating exchange rate can benefit the country. But due to its volatile nature, investors might not want to take higher risks.

This article is a guide to Floating Exchange Rate and its definition. We have discussed the advantages of floating exchange rate, disadvantages, and an example. You can learn more from the following Excel modeling articles: –

  • Exchange Rate FormulaExchange Rate RiskForeign Exchange RisksTranslation Exposure