A floating or flexible exchange rate system is one in which the exchange rate between currencies is determined purely by supply and demand of the currencies without any government intervention. The rates depend on the flow of money between the countries, which may either result due to international trade in goods or services, or due to purely financial flows. Hence in case of a deficit or surplus in the balance of payments, the exchange rates get automatically adjusted and this leads to a correction of the imbalance.
In a floating exchange rate system, economic parameters like price level changes, interest differentials, economic growth and government policies have an impact on the exchange rate as these factors influence the supply and demand of currencies.
A purely floating exchange rate system is more of a theoretical benchmark rather than reality in practice. Most economies fall in between the two extremes — a rigidly fixed system and a purely floating system. The United States, the EU, and Japan are close to the flexible exchange rate system, although central banks of these countries intervene in the foreign exchange market from time to time.
Key features of a floating exchange rate system are:
- No government intervention required.
- Exchange rate determined by market forces.
- Frequent fluctuations.
- Balance of payments adjusts simultaneously with the exchange rate.
Floating exchange rates can be of two types:
- Free float: Under the free float, market exchange rates are determined by the interaction of currencies supply and demand. The supply and demand schedules, in turn, are influenced by price level changes, interest differentials and economic growth. As these economic parameters change, market participants will adjust their current and expected future currency needs. There is no intervention either by the government or by the central bank.
- Managed float: In the free float, there is always an uncertainty in exchange rate movements that reduce economic efficiency by acting as a tax on trade and foreign investments. In order to reduce the volatility associated with the free float, the central bank generally intervenes in the currency markets to smoothen the fluctuations. Such a system of managed exchange rates is referred to as a managed float or a dirty float.
There are three approaches to manage the float:
- Smoothing out daily fluctuations: The central bank may occasionally enter the market on the buy or sell side to ease the transition from one rate to another, rather than resist fundamental market forces, tending to bring about long-term currency appreciation or depreciation.
- “Leaning against wind”: This approach is an intermediate policy designed to moderate an abrupt short and medium-term fluctuations brought about by random events whose effects are expected to be only temporary. Intervention may take place to prevent these short and medium-term effects, while letting the markets find their own equilibrium rates in the long-term, in accordance with the fundamentals.
- Unofficial pegging: In the third variation, though officially the exchange rate may be floating, in reality the central bank may intervene regularly in the currency market, thus unofficially keeping it fixed.
Advantages of Floating Exchange Rate System
- Since the country is not required to defend the exchange rate at a certain level, the government and central bank are free to choose independent domestic macroeconomic policies to deal with domestic issues such as inflation or unemployment.
- Under floating exchange rate regime, market intervention by the central bank is not required to defend the exchange rate.
- Since there is no need for market intervention, there is only very low requirement for international reserves.
- For countries that lack monetary and fiscal disciplines, a floating exchange rate sets no pressure for a country to observe these disciplines.
Disadvantages of Floating Exchange Rate System
- Floating exchange rate system is susceptible to large swings in the exchange rate causing substantial swings in the real economy, especially in the case of small emerging market economies where exports, imports, and international capital flows make up a relatively large share of the economy.
- Floating exchange rate system provides uncertainty and exchange rate risk in international trade and investment. Although exchange rate risk could be hedged under a floating exchange rate regime, such hedges could be expensive.
- Since the volatility in exchange rate is higher under floating exchange rate system, any depreciation of the domestic currency may disrupt the financial system, especially in the case of a country where banks make significant loans in foreign currency.