Floating Exchange Rate
What is Floating Exchange Rate?
A floating exchange rate is determined freely by market supply and demand without government intervention.
Most major currencies, such as the dollar and euro, float. Rates adjust automatically to trade and capital flows but can be volatile. It contrasts with a fixed exchange rate, which a government pegs.
Floating Exchange Rate: a worked example
Suppose the drav, the currency of Dravia, trades at 1.20 dollars per drav. Stronger foreign demand for Dravian machinery shifts the demand for dravs right, and the new equilibrium settles at 1.32 dollars per drav. The drav appreciated by (1.32 - 1.20) ÷ 1.20 = 10 percent. Now flip the quote to price the dollar instead: 1 ÷ 1.20 = 0.833 dravs per dollar before, 1 ÷ 1.32 = 0.758 dravs per dollar after, so the dollar depreciated by (0.758 - 0.833) ÷ 0.833 = 9.1 percent. A machine listed at 600 dravs cost 600 × 1.20 = 720 dollars before the move and 600 × 1.32 = 792 dollars after, so a dollar buyer pays 72 dollars more for an unchanged drav price.
The mistake students make with floating exchange rate
Students treat a 10 percent appreciation of the drav and a 10 percent depreciation of the dollar as the same statement. One movement in one market seems to deserve one number, so the percentage gets copied across. The two differ because each is measured against a different base. Going from 1.20 to 1.32 dollars per drav is a 10 percent rise for the drav but only a 9.1 percent fall for the dollar, since 0.758 is compared with 0.833. Compute the percentage in the units the question actually asks about.
Floating Exchange Rate questions
What causes a floating exchange rate to change?
Anything that shifts demand for or supply of a currency moves a floating rate. Higher domestic interest rates attract foreign savers who must buy the currency first, so it appreciates. Faster domestic inflation, weaker export demand, and investors moving money abroad all push it down. Expectations matter too, since traders buying today because they expect appreciation tomorrow create the very demand that lifts the rate.
Is a weaker currency good or bad for an economy?
A weaker currency helps and hurts different groups at the same time. Exporters gain because their goods look cheaper to foreign buyers, so net exports and aggregate demand rise. Households and firms lose because imported goods, fuel, and foreign parts cost more, which adds to inflation. A country carrying debt priced in a foreign currency finds repayment harder. The overall effect depends on how much the country imports and how quickly export volumes respond.
How is a floating exchange rate different from a fixed one?
Floating rates are set entirely by currency supply and demand, so they adjust continuously and need no reserves to maintain. Fixed rates are held at an announced value by a central bank that buys and sells its own currency to absorb any imbalance. Floating rates let a country run independent monetary policy but tolerate volatility. Fixed rates deliver predictability for traders and borrowers at the cost of holding reserves and surrendering control of interest rates.
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