Floating Exchange Rate - The pros and cons

February 22, 2021 16:00 UTC
Reading time: 13 minutes

 

Before we get to the concept of the floating exchange rate and the floating currency, let's review the fixed exchange rate a little - things are known by their opposites.

The fixed exchange rate is the official rate set by the monetary authorities for one or more currency. In fact, fluctuation can be observed between upper and lower volatility patterns, which ultimately leads to the central bank's intervention to stabilize the exchange rate.

This system means, as the name indicates, that the exchange rate for a particular currency pair is fixed. The exchange rate is determined according to this system through the currency parity on a specific base of gold or a major currency, or on the basis of gold or a basket of currencies. 

The major principal or raw material from which countries are obligated under this system to directly determine the value of the local currency (such as gold, in most cases), leads to the stability of the exchange rate.

A fixed exchange rate means that you will always get the same value for your money in the base currency, and will be given the same exchange rate every time.

Having a fixed exchange rate can give the currency a kind of stability and make financial transactions more consistent and manageable. However, this means that your currency is affected by the value of the currency it is fixed (pegged) to, whether it is rising or falling.

In some cases, the government decides on a monetary policy that divides the risk of changing the value between multiple currencies in different proportions - between two or more currencies. This is done with the aim of reducing the risk of full exposure and dependence on the value of a single currency.

Now that we have made a simple explanation on the fixed exchange rate, let's start our discussion of the floating currency and the floating exchange rate.

Floating Exchange Rate - What does floating currency mean?

To float a currency is to make the exchange rate of this currency fully liberalized, so that the government or the central bank does not interfere in setting it directly. Rather, it is automatically emptied into the currency market through a supply and demand mechanism that allows setting the national currency's exchange rate against foreign currencies.

Floating currency exchange rates fluctuate constantly with every change in the supply and demand of foreign currencies, so that they can change even several times per day.

The supply and demand for a currency is affected by a number of factors, including but not limited to: 

  • Global trade
  • Interest rates
  • Foreign and international investment

Any or all of these factors will have a significant impact on the value of a currency in the international forex market. For example, in a country with a lot of foreign commercial investment, the demand for the local currency will increase, and this will lead to an increase in its value and exchange rate.

A floating currency price can be left to be determined only by market supply and demand and it can also be limited. When a floating exchange rate is limited, the government (through its central bank) intervenes as needed in order to direct the exchange rates when they become too high or too low by affecting the size of the supply or demand for foreign currencies.

Which is better: fixed or floating exchange rate?

Perhaps we can expect that both come with advantages and disadvantages, and choosing which is better depends largely on the individual financial and economic situation of a country.

We will discuss the advantages and disadvantages of floating currency later in this article.

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How does a floating exchange rate work?

More than $5 trillion is traded in the forex markets regularly, which is an enormous amount by any measure. All this amount is exchanged through the variable rates of different currencies, which is the price at which one currency can be exchanged for another. 

This means buying and selling one currency for another at certain prices. This can happen as a form of investment or as in some cases in our daily life, when you are trying to earn money for your next vacation or to move abroad.

As we previously discussed, the forces of supply and demand and factors such as the economic and financial health of a country determine the value of its currency, whether it is increasing or decreasing. Higher demand means higher value, while lower demand means lower value.

Using a floating currency can be considered a fiscal benefit when the economy is strong and fiscal policy is sound. But, if market sentiment towards the government and its monetary policy is weakened, it could lead to a devaluation of its currency.

However, policymakers may intervene in the floating exchange rate to keep the rates of their currency at a level suitable for foreign exchange - this often prevents coercion by other governments.

Pros of a floating exchange rate

It’s time I mention some of the benefits of a floating currency and how it can benefit the country's economy and encourage trade and investment in it.

  • Balance of Payments (BOP). Balance of Payments plays an important role in the local currency exchange rate. It refers to a statement of the transactions between one country and the rest of the world during a specified period of time.

In cases where the imbalance is a deficit, this will cause the currency to depreciate. This lowers the cost of the country's exports, creates higher demand, attracts more foreign investment, and ultimately a balance of payments.

  • Specific exchange rates from the market. Unlike fixed rate currencies, floating currencies are allowed to be traded in the currency markets without further management from central banks and governments throughout these operations.
    • High market efficiency. When currencies are based on a floating exchange, they tend to make investments between countries more flexible and attractive, and they can also boost a country's overall economy and domestic production.
  • Does not require large foreign currency reserves. When using the floating exchange rate, central banks do not need to hold large amounts of foreign exchange reserves to balance the exchange rate. Reserves can be used to stimulate economic development by purchasing capital goods.
  • Protection from import inflation. The problem of import inflation can result from a balance of payments surplus or rising costs of imports by countries with fixed exchange rates. However, countries with floating exchange rates don’t face this dilemma.

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Risks of a floating exchange rate

I’ve mentioned what the advantages of a floating currency are, but are there risks entailed with a floating currency? I’ll answer this question now.

  • Risk of volatility. Floating currencies are subject to fluctuations and are not predictable by default. One currency can decline in value against another currency within a single trading day. Additionally, short-term fluctuations cannot be explained by fundamental principles of macroeconomics in a currency with a floating exchange rate.
  • Limited economic growth and recovery. The lack of strict control over the currency exchange rate places restrictions on the growth and recovery of the economy in some cases. 

When the currency depreciates, it can lead to serious problems, such as export and import within certain countries. If the value of the euro depreciates against the US dollar, it will be difficult to import goods and products from the United States, for example.

  • It may not help in solving the country's current economic problems. When a country deals with economic issues such as high unemployment, high inflation, low GDP, for example, the floating exchange rate may not help it recover if the currency continues to depreciate. As such, inflation will increase, as will the demand for commodities. Not to mention that it could be relied upon for any kind of imports for important commodities, which would only make the problem even bigger.

An example of government intervention in a floating exchange rate

China's monetary policy, through the People's Bank of China, works to keep the yuan's exchange rate below its real value. They reflect regularly to devalue the yuan so that exports are cheaper for foreign countries, and to create higher demand for domestic production at very attractive rates.

With the floating exchange rate of the yuan against many other currencies, the US dollar is well dominated, and the People's Bank of China maintains trading around the dollar in ranges of up to 2%. They usually achieve this by printing more yuan and placing it on the market, creating reserves in other currencies, and buying US Treasury bonds.

As the yuan increases in supply, it also restricts the supply of other currencies it accumulates in its reserves.

Ready to trade currencies with a floating exchange rate?

Here is a list of eleven important points to consider when deciding to start trading fiat currencies with your broker:

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Searching for a competitive broker by focusing on low spreads offers is not necessarily the best idea, as the average spread offered does not guarantee that it applies to a particular type of trade as well.

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  • Forex Broker License - It is important to open an account with a regulated and licensed broker always, above all.
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