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In
macroeconomics Macroeconomics (from the Greek prefix ''makro-'' meaning "large" + ''economics'') is a branch of economics Economics () is a social science Social science is the branch A branch ( or , ) or tree branch (sometimes referred ...
and
economic policy The economic policy of government A government is the system or group of people governing an organized community, generally a state State may refer to: Arts, entertainment, and media Literature * ''State Magazine'', a monthly ...
, a floating exchange rate (also known as a fluctuating or flexible exchange rate) is a type of
exchange rate regime An exchange rate regime is a way a monetary authority In finance and economics, a monetary authority is the entity that manages a country’s currency and money supply, often with the objective of controlling inflation targeting, inflation, intere ...
in which a
currency A currency, "in circulation", from la, currens, -entis, literally meaning "running" or "traversing" in the most specific sense is money Image:National-Debt-Gillray.jpeg, In a 1786 James Gillray caricature, the plentiful money bags handed t ...

currency
's value is allowed to fluctuate in response to
foreign exchange market The foreign exchange market (Forex, FX, or currency market) is a global decentralized Decentralization or decentralisation is the process by which the activities of an organization, particularly those regarding planning and decision makin ...
events. A currency that uses a floating exchange rate is known as a ''floating currency'', in contrast to a ''
fixed currency A fixed exchange rate, sometimes called a pegged exchange rate, is a type of exchange rate regime in which a currency's value is fixed or pegged by a monetary authority against the value of another currency, a currency basket, basket of other curren ...
'', the value of which is instead specified in terms of material
goods In economics Economics () is a social science Social science is the branch A branch ( or , ) or tree branch (sometimes referred to in botany Botany, also called , plant biology or phytology, is the science of plant ...

goods
, another currency, or a set of currencies (the idea of the last being to reduce currency fluctuations). In the modern world, most of the world's currencies are floating, and include the most widely traded currencies: the
United States dollar The United States dollar (symbol A symbol is a mark, sign, or that indicates, signifies, or is understood as representing an , , or . Symbols allow people to go beyond what is n or seen by creating linkages between otherwise very diffe ...
, the
euro The euro (currency symbol, symbol: euro sign, €; ISO 4217, code: EUR) is the official currency of 19 of the Member state of the European Union, member states of the European Union. This group of states is known as the eurozone or euro area ...

euro
, the Swiss franc, the
Indian rupee The Indian rupee (symbol A symbol is a mark, sign, or that indicates, signifies, or is understood as representing an , , or . Symbols allow people to go beyond what is n or seen by creating linkages between otherwise very different s a ...
, the
pound sterling The pound sterling (symbol: £; ISO code: GBP), known in some contexts simply as the pound or sterling, is the official currency A currency, "in circulation", from la, currens, -entis, literally meaning "running" or "traversing" in the ...
, the
Japanese yen The is the official currency of Japan. It is the third most traded currency in the foreign exchange market The foreign exchange market (Forex, FX, or currency market) is a global decentralized Decentralization or decentralisation ...
, and the
Australian dollar The Australian dollar (sign A sign is an object Object may refer to: General meanings * Object (philosophy), a thing, being, or concept ** Entity, something that is tangible and within the grasp of the senses ** Object (abstract), ...
. However, even with floating currencies,
central bank A central bank, reserve bank, or monetary authority is an institution that manages the and of a or formal monetary union, and oversees their . In contrast to a , a central bank possesses a on increasing the . Most central banks also have ...

central bank
s often participate in markets to attempt to influence the value of floating exchange rates. The
Canadian dollar The Canadian dollar (symbol A symbol is a mark, sign, or that indicates, signifies, or is understood as representing an , , or . Symbols allow people to go beyond what is n or seen by creating linkages between otherwise very different ...
most closely resembles a pure floating currency because the
Canadian national bank
Canadian national bank
has not interfered with its price since it officially stopped doing so during 1998. The US dollar is a close second, with very little change of its
foreign reserves Foreign exchange reserves (also called forex reserves or FX reserves) are cash In economics Economics () is the social science that studies how people interact with value; in particular, the Production (economics), production, distr ...
. By contrast, Japan and the UK intervene to a greater extent, and India has medium-range intervention by its national bank, the
Reserve Bank of India The Reserve Bank of India (RBI) is India's central bank and regulatory body and is responsible for the Money creation, issue and money supply, supply of the Indian rupee and the Bank regulation, regulation of the Banking in India, Indian banki ...

Reserve Bank of India
. From 1946 to the early 1970s, the
Bretton Woods system The Bretton Woods system of monetary management established the rules for commercial and financial relations among the United States The United States of America (USA), commonly known as the United States (U.S. or US), or America, is a ...
made fixed currencies the norm; however, during 1971, the US government decided to discontinue maintaining the dollar exchange at 1/35 of an ounce of gold and so its currency was no longer fixed. After the end of the
Smithsonian Agreement The Smithsonian Agreement, announced in December 1971, created a new dollar standard, whereby the currencies of a number of industrialized states were pegged to the US dollar The United States dollar (symbol A symbol is a mark, sign, o ...
in 1973, most of the world's currencies followed suit. However, some countries, such as most of the Arab states of the Persian Gulf region, fixed their currency to the value of another currency, which has been associated more recently with slower rates of growth. When a currency floats, quantities other than the exchange rate itself are used to administer
monetary policy Monetary policy is the policy adopted by the monetary authority In finance and economics, a monetary authority is the entity that manages a country’s currency and money supply, often with the objective of controlling inflation targeting, infla ...

monetary policy
(see open-market operations).


Economic rationale

Some economists believe that in most circumstances, floating exchange rates are preferable to
fixed exchange rate A fixed exchange rate, sometimes called a pegged exchange rate, is a type of exchange rate regime in which a currency's value is fixed or pegged by a monetary authority against the value of another currency, a basket of other currencies, or anot ...
s. As floating exchange rates adjust automatically, they enable a country to dampen the effect of shocks and foreign
business cycles The business cycle, also known as the economic cycle or trade cycle, are the fluctuations of gross domestic product (GDP) around its long-term growth trend. The length of a business cycle is the period of time containing a single boom and contract ...
and to preempt the possibility of having a
balance of payments crisisA currency crisis is a situation in which serious doubt exists as to whether a country's central bank A central bank, reserve bank, or monetary authority is an institution that manages the currency and monetary policy of a State (polity), stat ...
. However, they also engender unpredictability as the result of their variability, which can render businesses' planning risky since the future exchange rates during their planning periods are uncertain. However, in certain situations, fixed exchange rates may be preferable for their greater stability and certainty. That 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
1997 Asian financial crisis The Asian financial crisis was a period of financial crisis that gripped much of East Asia and Southeast Asia beginning in July 1997 and raised fears of a worldwide economic meltdown due to financial contagion. The crisis started in Thailand (kno ...
. The debate of choosing between fixed and floating exchange rate methods is formalized by the
Mundell–Fleming model The Mundell–Fleming model, also known as the IS-LM-BoP model (or IS-LM-BP model), is an economics, economic model first set forth (independently) by Robert Mundell and Marcus Fleming. Reprinted in Reprinted in The model is an extension of the I ...
, which argues that an economy (or the government) cannot simultaneously maintain a fixed exchange rate, free capital movement, and an independent monetary policy. It must choose any two for control and leave the other to market forces. The primary argument for a floating exchange rate is that it allows monetary policies to be useful for other purposes. Using fixed rates, monetary policy is committed to the single goal of maintaining the exchange rate at its announced level. However, the exchange rate is only one of the many macroeconomic variables that monetary policy can influence. A system of floating exchange rates leaves monetary policymakers free to pursue other goals, such as stabilizing employment or prices. During an extreme appreciation or
depreciation In accountancy, depreciation refers to two aspects of the same concept: first, the actual decrease of fair value of an asset, such as the decrease in value of factory equipment each year as it is used and wear, and second, the allocation in a ...
of currency, a
central bank A central bank, reserve bank, or monetary authority is an institution that manages the and of a or formal monetary union, and oversees their . In contrast to a , a central bank possesses a on increasing the . Most central banks also have ...

central bank
will normally intervene to stabilize the currency. Thus, the exchange rate methods of floating currencies may more technically be known as managed float. A national bank might, for instance, allow a currency price to float freely between an upper and lower bound, a price "ceiling" and "floor". Management by a national 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.


Aversion to floating

A free floating exchange rate increases foreign exchange volatility. Some economists believe that this could cause serious problems, especially in developing economies. Those economies have a financial sector with one or more of following conditions: * high liability dollarization * financial fragility * strong balance sheet effects When
liabilities Liability may refer to: Law * Legal liability, in both civil and criminal law ** Public liability, part of the law of tort which focuses on civil wrongs ** Product liability, the area of law in which manufacturers, distributors, suppliers, reta ...
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. Therefore, developing countries seem to have greater aversion to floating, as they have much smaller variations of the nominal exchange rate but experience greater shocks and interest rate and reserve changes. This is the consequence of frequent free floating countries' reaction to exchange rate changes with
monetary policy Monetary policy is the policy adopted by the monetary authority In finance and economics, a monetary authority is the entity that manages a country’s currency and money supply, often with the objective of controlling inflation targeting, infla ...

monetary policy
and/or intervention in the foreign exchange market. The number of countries that show aversion to floating increased significantly during the 1990s.


See also

*
Domestic liability dollarizationDomestic liability dollarization (DLD) refers to the denomination of banking system deposits and lending in a currency other than that of the country in which they are held. DLD does not refer exclusively to denomination in US dollars, as DLD encompa ...
*
List of countries with floating currencies This is a list of countries by their exchange rate regime. No legal tender of their own US dollar as legal tender Legal tender is a form of money that courts of law are required to recognize as satisfactory payment for any monetary debt. Eac ...
*
Currency appreciation and depreciation Currency depreciation is the loss of value of a country's currency A currency, "in circulation", from la, currens, -entis, literally meaning "running" or "traversing" in the most specific sense is money Money is any item or veri ...


References


Further reading


Exchange rate and fiscal performance. Do fixed exchange rate regimes generate more discipline than flexible ones?
Vúletin, Guillermo Javier. April 2002. {{DEFAULTSORT:Floating Exchange Rate Foreign exchange market