Floating Exchange Rates

Definition

Floating exchange rates are a system where the value of a country's currency is determined by the foreign exchange market through supply and demand. The exchange rate fluctuates based on various economic factors and is not actively managed by the government or central bank.

5 Must Know Facts For Your Next Test

1. Floating exchange rates allow a currency's value to adjust automatically to changes in supply and demand, which can help a country's economy adapt to external shocks.
2. Governments may still intervene in the foreign exchange market to influence the value of their currency, even under a floating exchange rate system.
3. Floating exchange rates can lead to greater volatility in currency values, which can impact international trade, investment, and financial stability.
4. Floating exchange rates are often associated with greater economic flexibility and independence in monetary policy, as central banks can adjust interest rates without being constrained by fixed exchange rate commitments.
5. The choice between floating and fixed exchange rate regimes is a key policy decision for countries, with trade-offs between economic stability, competitiveness, and policy autonomy.

Review Questions

• Explain how floating exchange rates differ from fixed exchange rates and the implications for a country's economic policy.
  • Floating exchange rates are determined by the foreign exchange market, while fixed exchange rates are pegged to another currency or a basket of currencies and actively managed by the government or central bank. Floating exchange rates provide more flexibility for a country's monetary policy, as the central bank can adjust interest rates without being constrained by maintaining a fixed exchange rate. However, floating exchange rates can also lead to greater currency volatility, which can impact international trade, investment, and financial stability. Governments may still intervene in the foreign exchange market to influence the value of their currency, even under a floating exchange rate system.
• Describe how the concept of purchasing power parity (PPP) relates to floating exchange rates and the determination of a currency's value.
  • Purchasing power parity (PPP) is an economic theory that states the exchange rate between two currencies should equalize the price of a basket of goods and services in those countries, adjusting for inflation. Under a floating exchange rate system, the currency's value is determined by the foreign exchange market based on supply and demand. The PPP theory suggests that if a currency is undervalued relative to its PPP, it should appreciate over time to restore the equilibrium. However, in practice, various factors, such as trade imbalances, capital flows, and speculative activity, can cause a currency's value to deviate from its PPP-implied level, leading to persistent misalignments under a floating exchange rate regime.
• Evaluate the potential advantages and disadvantages of a floating exchange rate system for a country's economic performance and stability, particularly in the context of 16.4 Exchange Rate Policies.
  • Floating exchange rates can provide several advantages for a country's economic performance and stability. They allow the currency's value to adjust automatically to changes in supply and demand, which can help the economy adapt to external shocks and maintain competitiveness. Floating rates also provide greater independence in monetary policy, as central banks can adjust interest rates without being constrained by fixed exchange rate commitments. However, floating exchange rates can also lead to greater currency volatility, which can impact international trade, investment, and financial stability. Governments may still intervene in the foreign exchange market to influence the value of their currency, even under a floating exchange rate system, as part of their broader exchange rate policies. The choice between floating and fixed exchange rate regimes is a key policy decision for countries, with trade-offs between economic stability, competitiveness, and policy autonomy.

Related terms

Fixed Exchange Rates: A system where a country's currency value is pegged to another currency or a basket of currencies, and the exchange rate is maintained within a narrow range through government intervention.

Managed Floating: A hybrid system where the exchange rate is allowed to fluctuate within a certain range, but the government or central bank may intervene to influence the currency's value.

Purchasing Power Parity (PPP): An economic theory that states the exchange rate between two currencies should equalize the price of a basket of goods and services in those countries, adjusting for inflation.