In the world of finance, exchange rates play a pivotal role in determining the value of one currency relative to another. Among the various types of exchange rate systems, the floating exchange rate stands out due to its dynamic nature and widespread adoption.
Floating exchange rates are the most common mechanism used in the global currency markets and allow currencies to establish their value in relation to each other. This article delves into the concept of floating exchange rates, exploring their significance, types, and implications for forex trading.
What is a floating exchange rate?
A floating exchange rate is a system in which the value of a currency is dynamically determined by market forces. The process applies the fundamental laws of demand and supply. If demand for a currency increases, so does the price – as reflected in a higher exchange rate.
Tip: Monitor key economic indicators such as inflation rates, interest rates, and GDP growth, using an Economic Calendar.
Unlike fixed exchange rates, which are pegged to another currency or a basket of currencies, floating exchange rates fluctuate freely. This means that the exchange rate can change from day to day, minute to minute, and in real time. The factors which drive price moves include macroeconomic conditions such as interest rates, inflation, national production levels, market sentiment, and geopolitical events.
The reason for a floating exchange rate
The primary advantage of a floating exchange rate is its ability to adjust naturally to changes in the global economy. This flexibility allows countries to absorb external shocks more effectively, as the exchange rate can shift to reflect new economic realities.
For instance, if a country’s economy is experiencing inflation, a floating exchange rate can help mitigate the impact by allowing the currency to depreciate, making exports cheaper and imports more expensive.
Another reason to adopt the floating exchange rate approach is that managing a fixed exchange rate mechanism can be difficult to do. If international investors perceive the pegged rate to be unrealistic, they can take speculative positions in anticipation of a change to the fixed level. As the forex market is the largest financial market in the world, huge capital flows from international investors can overwhelm the budgets of governments trying to “buck the market”.
Under the floating exchange rate system, governments and central banks can instead adopt strategies to control money supply and ensure economic stability with their focus being on domestic economic conditions. They are not constrained by the need to set policies to maintain a fixed exchange rate.
Tip: Floating exchange rates react immediately to external economic shocks and allow an economy to readjust to new conditions.
Floating exchange rates are able to accommodate fluctuations in trade balances – the difference in value between what a country imports and exports. If country “A” exports more than it imports, the demand for its currency increases, because foreign counterparts need to buy the currency of country “A” to buy the goods they desire. In a similar way, a country which imports more than it exports will see its currency depreciate.
A floating exchange rate allows changes to the balance of trade to be reflected in currency appreciation or depreciation. A circular relationship develops, and a country which is “over-exporting” will see its products become relatively expensive on the global market purely due to changes in the exchange rate. Demand for those goods falls, and consequently, so does the exchange rate, until a new equilibrium is achieved.
Fixed vs floating exchange rates
The debate between fixed and floating exchange rates is a long-standing one in economic circles. Each system has its own set of advantages and disadvantages, and the choice between them often depends on a country’s specific economic circumstances and policy objectives.
Fixed exchange rates provide stability and predictability in international transactions, as the value of the currency is maintained at a set level. This can be beneficial for countries that rely heavily on trade and investment, as it reduces exchange rate risk and encourages foreign investment. However, maintaining a fixed exchange rate can be challenging, as it requires a country to hold large reserves of foreign currency to defend the peg.
Tip: Governments of countries with fixed exchange rates may support the peg by trading currencies in the open market.
In contrast, floating exchange rates offer greater flexibility and autonomy in monetary policy. Countries with floating exchange rates can adjust interest rates and implement monetary policies that align with their economic goals without being constrained by the need to maintain a fixed exchange rate. However, the downside is that floating exchange rates can be volatile, leading to uncertainty in international transactions and potentially affecting trade and investment.
Types of currency flotation
Currency flotation can be categorised into two main types: free float and managed float. Understanding these types can provide insights into how countries manage their exchange rate systems.
- Free Float: In a free float system, the exchange rate is determined entirely by market forces without any government intervention. Countries with a free float system allow their currencies to fluctuate freely based on supply and demand dynamics. This system is prevalent in major economies such as the United States, Japan, and the Eurozone.
- Managed Float: Also known as a dirty float, a managed float system involves some degree of government intervention to stabilise the currency. Central banks may buy or sell currencies to influence exchange rates and prevent excessive volatility. This approach is often used by countries that want to maintain some control over their currency while still allowing for market-driven fluctuations. Examples include India and China, which employ managed float systems to varying degrees.
Tip: Derivative instruments such as futures and forwards are used to secure a currency deal at a future date.
Why is a floating exchange rate important for forex trading?
For forex traders, understanding floating exchange rates is crucial, as they create opportunities for traders to profit from currency fluctuations. Floating exchange rates can change rapidly in response to economic data, geopolitical events, and market sentiment and form long-term trends.
Forex trading relies heavily on the analysis of economic indicators and market trends to predict currency movements. In a floating exchange rate system, traders must stay informed about global developments and economic cycles and use technical and fundamental analysis to make trading decisions which match your risk profile and investment aims.
Final thoughts
Forex traders need to develop a solid understanding of how floating exchange rates work. That is because it is these types of currency pairs which fluctuate in value and can be traded.
Whether you are adopting short-term or long-term strategies, the sometimes sudden movements in variable exchange rate markets also present a risk. They are driven by powerful global forces which need to be understood.
Visit the eToro Academy to learn more about the currency markets.
FAQs
- When are the forex markets open?
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The forex markets operate on a 24/5 basis. The trading week in the currency markets starts during the Sydney session on Monday morning and finishes when the US forex exchanges close on Friday evening.
- Who sets interest rates?
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Interest rates are set at a national level with governments and central banks responsible for determining what the base interest rate is. Different countries adopt different approaches in terms of whether the government or central bank have a greater say in determining rates. It is thought that central banks such as the US Federal Reserve, adopt a more principled approach and focus on long-term objectives and macroeconomic cycles, whereas governments may be tempted to set interest rates in line with short-term political developments, such as an upcoming election.
- What was the gold standard?
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The gold standard was a monetary system where a country’s currency was directly tied to a specific weight of gold. The value of a country’s currency was defined by its gold reserves, and citizens could exchange their paper currency for gold at a set rate. Adoption of the gold standard declined through the 20th century as central banks and governments saw benefit in being able to print (and spend) money which wasn’t backed by gold. As a result, exchange rates of most of the world’s currencies are now determined by economic factors.
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This communication is for information and educational purposes only and should not be taken as investment advice, a personal recommendation, or an offer of, or solicitation to, buy or sell any financial instruments. This material has been prepared without taking any particular recipient’s investment objectives or financial situation into account, and has not been prepared in accordance with the legal and regulatory requirements to promote independent research. Any references to the past or future performance of a financial instrument, index or a packaged investment product are not, and should not be taken as, a reliable indicator of future results. eToro makes no representation and assumes no liability as to the accuracy or completeness of the contents of this publication.