Floating exchange rate
In macroeconomics and economic policy, a floating exchange rate (also known as a fluctuating or flexible exchange rate) is a type of exchange rate regime in which a currency's value is allowed to fluctuate in response to foreign exchange market events.[1] A currency that uses a floating exchange rate is known as a floating currency, in contrast to a fixed currency, the value of which is instead specified in terms of material goods, another currency, or a set of currencies (the idea of the last being to reduce currency fluctuations).[2]
In the modern world, most of the world's currencies are floating, and include the most widely traded currencies: the United States dollar, the euro, the Swiss franc, the Indian rupee, the pound sterling, the Japanese yen, and the Australian dollar. However, even with floating currencies, central banks often participate in markets to attempt to influence the value of floating exchange rates. The Canadian dollar has not seen interference by the Canadian national bank with its price since 1988. The US dollar also sees very little change of its foreign reserves. By contrast, Japan and the UK central banks intervene to a greater extent, and India has medium-range intervention by its national bank, the Reserve Bank of India.
From 1946 to the early 1970s, the Bretton Woods system 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.[3] After the end of the Smithsonian Agreement 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 (see open-market operations).
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:
When liabilities 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.[4] This is the consequence of frequent free floating countries' reaction to exchange rate changes with monetary policy and/or intervention in the foreign exchange market.
The number of countries that show aversion to floating increased significantly during the 1990s.[5]