Floating Exchange Rate

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A floating exchange rate or fluctuating exchange rate is a type of exchange rate regime wherein a currency 's value is allowed to fluctuate according to the foreign exchange market. A currency that uses a floating exchange rate is known as a floating currency.

There are economists who think that, in most circumstances, floating exchange rates are preferable to fixed exchange rates. As floating exchange rates automatically adjust, they enable a country to dampen the impact of shocks and foreign business cycles, and to preempt the possibility of having a balance of payments crisis. However, in certain situations, fixed exchange rates may be preferable for their greater stability and certainty. This may not necessarily be true, considering the results of countries that attempt to keep the prices of their currency "strong" or "high" relative to others, such as the UK or the Southeast Asia countries before the Asian currency crisis. The debate of making a choice between fixed and floating exchange rate regimes is set forth by the Mundell-Fleming model, which argues that an economy cannot simultaneously maintain a fixed exchange rate, free capital movement, and an independent monetary policy. It can choose any two for control, and leave third to the market forces.

In cases of extreme appreciation or depreciation, a central bank will normally intervene to stabilize the currency. Thus, the exchange rate regimes of floating currencies may more technically be known as a managed float. A central bank might, for instance, allow a currency price to float freely between an upper and lower bound, a price "ceiling" and "floor". Management by the central bank may take the form of buying or selling large lots in order to provide price support or resistance, or, in the case of some national currencies, there may be legal penalties for trading outside these bounds.

Criticism of Floating Exchange Rate

A free floating exchange rate increases foreign exchange volatility. There are economists who think that this could cause serious problems, especially in emerging economies. These economies have a financial sector with one or more of following conditions:

  • high liability dollarization
  • financial fragility
  • strong balance sheet effects

When liabilities are denominated in foreign currencies while assets are in the local currency, unexpected depreciations of the exchange rate deteriorate bank and corporate balance sheets and threaten the stability of the domestic financial system. For this reason emerging countries appear to face greater fear of floating, as they have much smaller variations of the nominal exchange rate, yet face bigger shocks and interest rate and reserve movements. This is the consequence of frequent free floating countries' reaction to exchange rate movements with monetary policy and/or intervention in the foreign exchange market. The number of countries that present fear of floating increased significantly during the nineties.