Floating exchange rate

  Residual (other managed arrangement)

In

In the modern world, most of the world's currencies are floating, and include the most widely traded currencies: the

]

From 1946 to the early 1970s, the

open-market operations

).

Economic rationale

Foreign exchange
Exchange rates
Currency band Exchange rate Exchange rate regime Exchange-rate flexibility Dollarization Fixed exchange rate Floating exchange rate Linked exchange rate Managed float regime Dual exchange rate
Markets
Foreign exchange market Futures exchange Retail foreign exchange trading
Assets
Currency Currency future Currency forward Non-deliverable forward Foreign exchange swap Currency swap Foreign exchange option
Historical agreements
Bretton Woods Conference Smithsonian Agreement Plaza Accord Louvre Accord
See also
Bureau de change Hard currency Currency pair Foreign exchange fraud Currency intervention
v t e

Some economists believe that in most circumstances, floating exchange rates are preferable to

. However, they also engender unpredictability as the result of their variability, which can render businesses' planning risky since the future exchange rates during their planning periods are uncertain.

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

1997 Asian financial crisis

.

The debate of choosing between fixed and floating exchange rate methods is formalized 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. Using fixed rates, monetary policy is committed to the single goal of maintaining the exchange rate at its announced level. However, the exchange rate is only one of the many macroeconomic variables that monetary policy can influence. A system of floating exchange rates leaves monetary policymakers free to pursue other goals, such as stabilizing employment or prices.

During an extreme

. A national bank might, for instance, allow a currency price to float freely between an upper and lower bound, a price "ceiling" and "floor". Management by a national 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.

Aversion to floating

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:

• 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.

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]

See also

• Domestic liability dollarization
• List of countries with floating currencies
• Currency appreciation and depreciation

References

Further reading