A floating exchange rate refers to currencies that are allowed to change freely, as influenced by an open market, rather than being fixed to the value of another currency.
A floating exchange rate system determines a currency’s value in relation to other currencies.
Unlike fixed exchange rates, these currencies are in continuous fluctuation and float freely. They are unrestrained by government controls or trade limits.
Changes in factors such as interest rates, inflation, political stability, capital flows, trade flows, employment, tourism, and speculation, maintain free-floating currencies in continuous movement.
This volatility is perceived as a good thing for currency speculators, who account for the vast majority of forex trading.
For companies carrying out business in foreign currencies, however, it poses translation and currency risk that might seriously impact their profit margins.
Advantages of a floating exchange rate
- Balance of payments stability
Theoretically, imbalances in the balance of payments lead to automatic changes in exchange rates. For example, a deficit in the balance of payments would trigger currency depreciation.
This would make a country’s exports cheaper in foreign markets, increasing their demand and ultimately restoring equilibrium in the balance of payments.
- No restrictions on foreign exchange and capital flows
Unlike with a fixed exchange rate, there are no restrictions to trade with these currencies. Therefore, there is no need for a constant management process on the part of the government or central bank.
- No need to keep large foreign currency reserves
Free-floating exchange rates do not require the central bank to keep large amounts of foreign currency reserves to defend the exchange rate. Those reserves, therefore, can be used to import capital goods to promote economic growth.
- Protection against imported inflation
One of the biggest problems facing countries with fixed exchange rates is that they may import inflation via higher import prices or through the balance of payments surpluses with regard to deficit countries. Countries with free-floating exchange rates do not have that problem.
Disadvantages of a floating exchange rate
- High level of exposure to exchange rate volatility
By nature, floating exchange rates are volatile and prone to sharp fluctuations. The value of a currency against another can drop precipitously in a single day.
- Lack of currency control can curtail economic recovery or growth
Negative exchange rate movements for a country’s currency can create serious problems.
For example, if the Japanese yen arises against the euro, it makes exporting to the eurozone from Japan more difficult.