Floating exchange rate
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This article needs attention from an expert in Economics. (November 2008) |
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A floating exchange rate(Faisal Ikram & Ghulam Raza) or fluctuating exchange rate is a type of exchange rate regime wherein a currency's value is allowed to fluctuate according to the foreign exchange market. A currency that uses a floating exchange rate is known as a floating currency. A floating currency is contrasted with a fixed currency.
In the modern world, the majority of the world's currencies are floating. Central banks often participate in the markets to attempt to influence exchange rates. Such currencies include the most widely traded currencies: the United States dollar, the euro, the Norwegian krone, the Japanese yen, the British pound, the Swiss franc and the Australian dollar. The Canadian dollar most closely resembles the ideal floating currency as the Canadian central bank has not interfered with its price since it officially stopped doing so in 1998. The US dollar runs a close second with very little change in its foreign reserves; by contrast, Japan and the United Kingdom intervene to a greater extent.
From 1946 to the early 1970s, the Bretton Woods system made fixed currencies the norm; however, in 1971, the United States government would no longer uphold the dollar exchange at 1/35th of an ounce of gold, so that the US dollar was no longer a fixed currency. After the 1973 Smithsonian Agreement, most of the world's currencies followed suit. Few countries fixed their currency with another currency, however, lately some of these countries are causing their economy to slow it's growth. For example, most of the Gulf States had their currency fixed with the US Dollar, and by this strategy it resulted in one outcome, that is dragging their currency value down with the US Dollar declining value. A floating currency is one where targets other than the exchange rate itself are used to administer monetary policy. See open market operations.
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Economic rationale [edit]
There are economists who think that in most circumstances, floating exchange rates are preferable to fixed exchange rates. As floating exchange rates automatically adjust, they enable a country to dampen the impact of shocks and foreign business cycles, and to preempt the possibility of having a balance of payments crisis. However, they also engender unpredictability as the result of their dynamism.
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 Asian currency crisis.
The debate of making a choice between fixed and floating exchange rate regimes is set forth by the Mundell–Fleming model, 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. Under fixed rates, monetary policy is committed to the single goal of maintaining exchange rate at its announced level. Yet the exchange rate is only one of the many macroeconomic variables that monetary policy can influence. A system of floating exchange rates leaves monetary policy makers free to pursue other goals such as stabilizing employment or prices.
In cases of extreme appreciation or depreciation, a central bank will normally intervene to stabilize the currency. Thus, the exchange rate regimes of floating currencies may more technically be known as a managed float. A central bank might, for instance, allow a currency price to float freely between an upper and lower bound, a price "ceiling" and "floor". Management by the central 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.
Fear of floating [edit]
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The examples and perspective in this section may not represent a worldwide view of the subject. (May 2010) |
A free floating exchange rate increases foreign exchange volatility. There are economists who think that this could cause serious problems, especially in emerging economies. These economies have a financial sector with one or more of following conditions:
- high liability dollarization
- financial fragility
- strong balance sheet effects
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.
For this reason emerging countries appear to face greater fear of floating, as they have much smaller variations of the nominal exchange rate, yet face bigger shocks and interest rate and reserve movements.[1] This is the consequence of frequent free floating countries' reaction to exchange rate movements with monetary policy and/or intervention in the foreign exchange market.
The number of countries that present fear of floating increased significantly during the 1990s.[2]
See also [edit]
General:
References [edit]
- ^ Calvo, G.; Reinhart, C. (2002). "Fear of Floating". Quarterly Journal of Economics 117 (2): 379–408. doi:10.1162/003355302753650274.
- ^ Levy-Yeyati, E.; Sturzenegger, F. (2005). "Classifying Exchange Rate Regimes: Deeds vs. Words". European Economic Review 49 (6): 1603–1635. doi:10.1016/j.euroecorev.2004.01.001.
