Floating Exchange Rate System
The Floating Exchange Rate System is a system of exchange rate determination which allows the value of different currencies to fluctuate according to the foreign exchange market. It is a concept established by the IMF in the 1970s as a result of détente between the United States and the Soviet Union. The system replaced the gold standard, which was used from the 18th Until the late 19th century. The floating exchange rate system is the most common system used today.
The floating exchange rate system allows for the value of a particular currency to rise and fall relative to other currencies in response to economic and political conditions in different countries, and in particular to changes in the demand for and/or supply of a currency. In general, a countrys currency will be in greater demand (causing its value to rise relative to other currencies) if that countrys economy is perceived to be growing rapidly, while the currency will be in lower demand relative to other currencies if the domestic economy is perceived to be in decline. Furthermore, political factors such as a governments stability and policy outlook can also significantly influence the value of a countrys currency.
In the floating exchange rate system, the foreign exchange (forex) market is where currencies are bought and sold. This market is known as an interbank market, meaning there is no centralized exchange on which all trades must take place. Thus, the forex consists of a network of traders who trade currencies 24 hours per day, five days a week. When a trader wishes to buy a currency, they do so by entering into a transaction with another trader in the interbank market who is willing to sell that currency. This often involves a spread, which is the difference between the buying price and selling price of the currency. The presence of this spread helps to ensure that both parties involved in the transaction benefit from the trade.
When a country’s currency weakens or strengthens relative to other currencies in the forex market, this is known as an exchange rate movement. This exchange rate movement is usually measured in percentage terms and can be a result of one or several factors. One example is an increase in demand for the currency, resulting in a rise in exchange rate. Alternatively, a decrease in demand could result in the opposite effect and cause the currency’s value to fall relative to other currencies. Changes in a country’s interest rates and how the currency is managed by its central bank can also have an effect on the exchange rate. Generally, currency will strengthen if the country’s central bank intervenes and buys up that particular currency in the forex market.
In a floating exchange rate system, governments and central banks generally commit to intervening only when the exchange rate moves past the point of equilibrium, meaning the rate reaches an unsustainable level. This is done to help prevent extreme volatility in the currency markets, which could be damaging to the global economy. Additionally, central banks may pursue additional strategies to stabilize the currency, such as setting targets for exchange rates or buying/selling certain currencies in the forex markets.
The floating exchange rate system has been widely adopted by countries around the world and has helped promote global trade by allowing all countries to use the same currency values. However, this system also brings with it unique risks, including the potential for sudden and large changes in exchange rates. It is therefore important for countries to understand and appreciate the impact that a floating exchange rate system can have on their economic and financial stability.
