What is a 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.
Floating Exchange 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 favorable 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.
How a Floating Exchange Rate Works
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, rumors, 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 favorable price.
Floating Versus Fixed Exchange Rates
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.
History of Floating Exchange Rates via the Bretton Woods Agreement
The Bretton Woods Conference, which established a gold standard for currencies, took place in July 1944. A total of 44 countries met, with attendees limited to the Allies in World War II. The Conference established the International Monetary Fund (IMF) and the World Bank, and it set out guidelines for a fixed exchange rate system. The system established a gold price of $35 per ounce, with participating countries pegging their currency to the dollar. Adjustments of plus or minus one percent were permitted. The U.S. dollar became the reserve currency through which central banks carried out intervention to adjust or stabilize rates.
The first large crack in the system appeared in 1967, with a run on gold and an attack on the British pound that led to a 14.3% devaluation. President Richard Nixon took the United States off the gold standard in 1971.
By late 1973, the system had collapsed, and participating currencies were allowed to float freely.
Failed Attempt to Intervene in a Currency
In floating exchange rate systems, central banks buy or sell their local currencies to adjust the exchange rate. This can be aimed at stabilizing a volatile market or achieving a major change in the rate. Groups of central banks, such as those of the G-7 nations (Canada, France, Germany, Italy, Japan, the United Kingdom, and the United States), often work together in coordinated interventions to increase the impact.
An intervention is often short-term and does not always succeed. A prominent example of a failed intervention took place in 1992 when financier George Soros spearheaded an attack on the British pound. The currency had entered the European Exchange Rate Mechanism (ERM) in October 1990; the ERM was designed to limit currency volatility as a lead-in to the euro, which was still in the planning stages. Soros believed that the pound had entered at an excessively high rate, and he mounted a concerted attack on the currency. The Bank of England was forced to devalue the currency and withdraw from the ERM. The failed intervention cost the U.K. Treasury a reported £3.3 billion. Soros, on the other hand, made over $1 billion.
Central banks can also intervene indirectly in the currency markets by raising or lowering interest rates to impact the flow of investors' funds into the country. Since attempts to control prices within tight bands have historically failed, many nations opt to free float their currency and then use economic tools to help nudge it one direction or the other if it moves too far for their comfort.