A floating exchange rate represents a regime where a nation’s currency price is determined by the forex market based on supply and demand dynamics relative to other currencies. Unlike a fixed exchange rate, where the government predominantly or entirely sets the rate, a floating rate allows market forces to pave the way.
Key Takeaways
- A floating exchange rate is determined by supply and demand in the open market.
- Governments and central banks still intervene to keep their currency prices favorable, even in floating regimes.
- Fixed exchange rates peg a currency to another, holding it at a specific value.
- Floating exchange rates gained popularity after the collapse of the gold standard and the Bretton Woods agreement.
Floating Exchange Rate
How a Floating Exchange Rate Works
Floating exchange rate systems indicate that long-term currency price changes generally mirror relative economic strength and interest rate differentials among countries.
Short-term movements in floating rate currencies often result from speculation, rumors, disasters, and everyday changes in supply and demand. If supply exceeds demand, the currency’s value will dip; conversely, if demand surpasses supply, the value will rise.
Extreme short-term fluctuations might prompt interventions by central banks, ensuring that the currency remains stable. While many leading global currencies float, governments or central banks can still act if their currency’s value threatens economic stability.
A currency that’s too high or too low can adversely impact the nation’s economy, including trade difficulties and debt repayment challenges. Governments or central banks may adopt measures to guide the currency towards a more favorable valuation.
Floating vs. Fixed Exchange Rates
Currency prices can be either floating or fixed. Floating rates align with the open market’s supply and demand principles. Hence, a high-demand currency increases in value, while a low-demand currency depreciates.
A fixed or pegged rate is set by a nation’s central bank against another major world currency (e.g., USD, EUR, or JPY). To maintain a fixed exchange rate, a government buys and sells its currency against the pegged currency. Examples include China and Saudi Arabia, which peg their currencies to the USD.
After the Bretton Woods system collapsed between 1968 and 1973, most of the world’s major economies allowed their currencies to float.
History of Floating Exchange Rates Via the Bretton Woods Agreement
The Bretton Woods Conference in July 1944 aimed to establish a gold standard for currencies, bringing 44 Allied nations together. The conference birthed the International Monetary Fund (IMF) and the World Bank, laying down the guidelines for a fixed exchange rate system.
The system set a gold price of $35 per ounce, with currencies pegged to the USD, allowing a 1% adjustment margin. Consequently, the USD became the reserve currency employed for central bank interventions.
In 1967, a significant crack emerged with an assault on the British pound, causing a 14.3% devaluation. Under President Richard Nixon, the U.S. abandoned the gold standard in 1971. By late 1973, Bretton Woods had collapsed, and currencies floated freely.
Failed Attempts to Intervene in a Currency
In turbulent floating exchange rate systems, central banks might buy or sell local currencies to stabilize or prompt significant exchange rate changes. Often, central banks, like those in the G-7, act collaboratively to maximize impact.
These short-term interventions aren’t always effective. For instance, in 1992, financier George Soros bet against the British pound, believing it was overvalued upon entering the Exchange Rate Mechanism (ERM). Following intense speculation, the Bank of England was forced to devalue the currency and exit the ERM, costing the U.K. Treasury an estimated £3.3 billion, while Soros netted a $1 billion profit.
Central banks can also indirectly impact currency markets by altering interest rates, influencing foreign investments. Given the historical failures of tight price controls, many nations prefer floating currencies, using economic tools to nudge values.
Example of a Floating Exchange Rate
Consider Day 1: 1 USD equals 1.4 GBP. On Day 2, 1 USD equals 1.6 GBP, and on Day 3, 1 USD equals 1.2 GBP. This example highlights fluctuating currency values driven by supply and demand. Conversely, in a fixed setup, 1 USD would always be 1.4 GBP.
Is the U.S. Dollar a Floating Exchange Rate?
Indeed, the U.S. dollar is a floating currency, its value dictated solely by its supply and demand, free from the constraints of being gold-backed or fixed against another currency.
Benefits of a Floating Exchange Rate
Benefits of a floating currency include the absence of large reserve requirements, eliminating the need for another commodity tie, managing inflation, and enabling internal goals (e.g., full employment).
The Bottom Line
Today, most countries leverage floating exchange rates, linking currency value to market supply and demand. This contrasts with historical practices of pegging currencies to assets like gold or setting fixed rates.
Related Terms: Forex, Currency Markets, Interest Rates, Fixed Exchange Rate.
References
- International Monetary Fund. “Reinventing the System (1972-1981)”.
- U.S. Department of State. “Bretton Woods-GATT, 1941-1947”.
- Federal Reserve History. “Creation of the Bretton Woods System”.
- Federal Reserve History. “Nixon Ends Convertibility of U.S. Dollars to Gold and Announces Wage/Price Controls”.
- Numismatic News. “The Failure of the 1960s London Gold Pool”.
- U.K. Parliament. “Exchange Rate Mechanism”.
- History Defined. “How George Soros Shorted the Pound and ‘Broke’ the Bank of England”.
