Floating Exchange Rate

Floating exchange rate is the price of a nation's currency in terms of the price of the currency of another nation that is determined by the foreign exchange market based on the demand and supply of the currencies. For example, if the equilibrium level of US$1 is at ¥107 on a particular day, the exchange rate between U.S. dollars and Japanese yen is said to be ¥107/US$. When demand for yen increases, the value of yen appreciates and the floating exchange rate reaches ¥105/US$. In order for the floating exchange rate to work, currency systems in both the United States and Japan need to be in the floating exchange rate zone.

After the establishment of the Smithsonian Agreement in 1971 when the U.S. dollar was devalued to $38 for an ounce of gold (from $35), a wider band with 4.5 percent fluctuation was adopted in the fixed exchange rate system. When the U.S. dollar was devalued again in 1973 to $42.22 for an ounce of gold, the United States and other nations began the floating exchange rate system.

There are, however, two forms of floating exchange rate in the system, the managed floating and the freely floating; the former was adopted initially in 1973. A mirror image of the adjustable fixed exchange rate system, where government intervenes to keep the exchange around a pegged rate, the managed floating exchange rate regime follows the principle of a floating exchange rate yet with government intervention, though with reluctance, to prevent extreme movement of its currency that could interfere with its trade and investments in the international market. In the freely floating case, a country allows its currency to fluctuate based solely on the market mechanism of currency trading. Strictly speaking, a nation's exchange rate under the floating system depends on the demand and supply of the nation's currency relative to other currencies in the foreign-exchange market.

The rationale behind the floating exchange rate system is its “autocorrection” mechanism. For example, when the interest rate was reduced by the Federal Reserve Bank in the United States in 2008 during the credit crisis, the U.S. dollar depreciated initially relative to currencies of its major trading partners, a phenomenon that makes U.S. goods and services less expensive to foreign buyers. However, the U.S. dollar also appreciated from time to time [Page 686]during the year due to high demand for the dollar as its exports accelerated and spending increased from international tourists.

The demand and supply of a country's currency is largely influenced and counterbalanced by the movement of its balance of payments, the effect of its monetary policy, and the dynamics and expectations that global trades bring to its economy on the foreign exchange market. And when the fluctuation of the currency becomes too volatile, e.g., there is too much demand for U.S. goods that could cause higher inflation, the central bank may step in to buy dollars back, a form of managed floating exchange rate, in order to maintain the currency within a desirable boundary.

While the floating exchange rate system provides the balance power to a country's currency through the automatic correction of demand and supply in the foreign exchange market, the system also tends to be better protected from any unexpected economic or monetary movement of its trading partners. For example, under normal circumstances, when inflation in China reaches its 12-year high, its currency should depreciate to the level that U.S. importers would not pay a higher price than that before the inflation for China's exporting goods. Unlike the fixed exchange rate regime, countries under the floating exchange rate system do not need to maintain their currency at a fixed level. Subsequently, central banks are free to exert monetary policies needed for domestic economic development without interfering with its exchange rate system.

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