Floating Exchange Rate

Definition

A floating exchange rate is a regime where a currency's value is allowed to fluctuate based on the foreign exchange market's supply and demand. This is in contrast to a fixed exchange rate, where the value is pegged to another currency or basket of currencies. The floating exchange rate system is one of the key features of the modern global monetary system.

5 Must Know Facts For Your Next Test

1. Under a floating exchange rate, the currency's value fluctuates based on the market forces of supply and demand, rather than being artificially pegged by the government.
2. Floating exchange rates allow countries to have an independent monetary policy, as they are not constrained by the need to maintain a fixed exchange rate.
3. Floating exchange rates can help a country adjust to economic shocks, as the currency can depreciate to make exports more competitive and imports more expensive.
4. However, floating exchange rates can also lead to increased volatility and uncertainty, which can negatively impact international trade and investment.
5. Many major economies, including the United States, the Eurozone, and Japan, operate under a floating exchange rate regime.

Review Questions

• Explain how a floating exchange rate system works and how it differs from a fixed exchange rate system.
  • In a floating exchange rate system, the value of a currency is determined by the foreign exchange market based on the supply and demand for that currency. This is in contrast to a fixed exchange rate system, where the government or central bank sets the exchange rate and maintains it through intervention in the foreign exchange market. Floating exchange rates allow for greater flexibility and the ability to adjust to economic shocks, but they also introduce more volatility and uncertainty compared to fixed exchange rates.
• Discuss the macroeconomic effects of a floating exchange rate on a country's economy.
  • A floating exchange rate can have several macroeconomic effects on a country's economy. When the domestic currency depreciates, it makes exports more affordable for foreign buyers, leading to an increase in exports and a potential improvement in the country's trade balance. However, it also makes imports more expensive, which can lead to higher inflation. Additionally, a floating exchange rate can provide a buffer against external shocks, as the currency can adjust to absorb the impact. On the other hand, the increased volatility associated with a floating exchange rate can create uncertainty and negatively impact international trade and investment.
• Analyze how shifts in the demand and supply of foreign exchange can affect the equilibrium exchange rate under a floating exchange rate system.
  • $$ \begin{align*} \text{Demand for Foreign Exchange} &= f(Y, i, P, e) \\ \text{Supply of Foreign Exchange} &= f(Y, i, P, e) \\ \text{Equilibrium Exchange Rate} &= \frac{\text{Demand for Foreign Exchange}}{\text{Supply of Foreign Exchange}} \end{align*} $$ Under a floating exchange rate system, changes in the underlying determinants of demand and supply, such as national income (Y), interest rates (i), price levels (P), and expectations about future exchange rates (e), can shift the demand and supply curves in the foreign exchange market. These shifts will lead to a new equilibrium exchange rate that clears the market. For example, an increase in domestic income would increase the demand for foreign goods and services, shifting the demand for foreign exchange to the right and causing the domestic currency to depreciate. Analyzing these demand and supply dynamics is crucial for understanding exchange rate determination in a floating rate regime.

Related terms

Fixed Exchange Rate: A fixed exchange rate is a regime where a currency's value is pegged to another currency or a basket of currencies, with the exchange rate remaining relatively stable over time.

Foreign Exchange Market: The foreign exchange market is a global decentralized market for the trading of currencies. It determines the relative values of different currencies.

Exchange Rate Regime: An exchange rate regime is the way a country manages its currency in relation to other currencies and the foreign exchange market.