Floating Exchange Rate

A floating exchange rate allows changes, or in other words, fluctuation in the value of a country’s currency. The value changes depending on the conditions of the financial market. If any currency employs the floating exchange rate, that currency is commonly referred to as a floating currency. A country can never maintain the stability of its own currency, but this can only be made possible with an exchange rate in the financial market.

We can say that the rate is mostly determined by the fluctuations of supply and demand in the private market. A floating exchange rate system is often termed as a self correcting one. For example, it works on a basic rise and fall theory. If the demand for a currency is low, its value will naturally decrease. When there is a demand for domestic goods and services, the market gets corrected. And this helps the economy since more of local goods and services will create the need for more jobs domestically. So when you see from a broader sense, the floating rate is constantly changing and altering the market. In reality, we all know that there is no currency that is always fixed or is always floating, but they are all bound by various factors that manage the market.

The fluctuations in the floating rates are a huge advantage for the country because it helps in financial crisis. When there is a payment crisis for a country the impact of the foreign business cycles are huge. So mostly, people prefer the floating rate when compared to the fixed exchange rate. There are few conditions that fixed exchange rates take over the floating rates in a market. These were not successful and the results were clearly proved the differences of having the floating and the fixed rates. For example, countries like the United Kingdom and a few countries of Southeast Asia tried to keep their currencies strong at the time of Asian currency crisis. The results of this were not great and all the different countries who tried to keep the value of their currencies could not succeed. With a fixed regime, market pressures will also alter some changes in the exchange rates in the market. When a domestic currency does not reflect its true value against its pegged currency, there is black market that is formed. This black market is called so because it reflects the actual supply and demand. This is when the central bank will force and value or devalue the currency. This is done by the central bank so that the actual currency is in line with the referred rate.

The Mundell Fleming model argues that, no economy can maintain a fixed rate. It states that it is practically impossible to manage free capital movement, independent monetary policy and the floating exchange rate simultaneously. All three coincides and alters the management somehow. So usually two can be chosen to take care and the other one has to fall prey to the conditions of the private market.

Another key advantage in the fluctuations of the floating rate is that the fluctuations provide automatic adjustments. These occur since the fluctuations allow the government or any monetary authority to make the required changes. The central bank also intervenes to stabilize the currency by allowing the currency to float between a higher and a lower band that it fixes. In this way the central bank somehow manages the cases of extreme rise and falls in the market.