Explanation of the floating exchange rate

The floating exchange rate system is a currency exchange rate management system adopted by a country or region in which the exchange rate is determined by market supply and demand and the forces of the foreign exchange market relative to other currencies, allowing the exchange rate to fluctuate freely within a certain range. Compared to a fixed exchange rate system, a floating exchange rate system allows exchange rates to fluctuate with changes in market demand and supply, reflecting different economic factors and policy impacts. Understanding the terminology and analyzing the advantages and disadvantages of a floating exchange rate system can help traders in their trading.

A floating exchange rate refers to a country that does not set the fluctuation range of currency exchange rates and allows them to fluctuate freely based on the supply and demand situation of the foreign exchange market. After World War I, the currencies of major countries in the world broke away from the gold standard and implemented a short-term floating exchange rate system. After the collapse of the Bretton Woods system in 1973, countries around the world generally implemented floating exchange rates.

Floating exchange rates can be divided into two types: free floating and managed floating.

1. Free float, also known as clean float, refers to a government that does not take any measures to intervene in the foreign exchange market and completely allows free float.

2. Management float, also known as dirty float, refers to the exchange rate system in which a government intervenes in the foreign exchange market in certain circumstances to ensure a relatively stable exchange rate and avoid excessive fluctuations.

The floating exchange rates currently implemented by most countries are managed floating.

From the perspective of floating methods, the floating exchange rate system can be divided into three categories: individual floating, joint floating, and implementing a pegged policy.

1. A single float refers to the situation where the domestic currency does not have a fixed price relationship with any foreign currency, and it floats separately according to the supply and demand in the foreign exchange market, with the US dollar, Japanese yen, and other currencies floating separately.

2. Joint floating refers to the adoption of fixed exchange rates between currencies within a group of countries, setting the upper and lower limits for exchange rate fluctuations, and the obligation of the monetary authorities of each country to maintain a fixed exchange rate for currencies within the group while allowing other currencies outside of member countries to freely float. The member states of the European Economic Community adopt a joint floating system.

3. The implementation of a peg policy refers to a floating exchange rate system that pegs a major currency, special drawing rights, or European monetary unit and applies a fixed exchange rate to it while floating other currencies based on the fluctuations of the major currency. At present, many developing countries adopt pegged policies, and there is also an exchange rate system adjusted according to a set of indicators.

An analysis of the advantages and disadvantages of a floating exchange rate system:

Advantages:

1. Rapid market response: Under the floating exchange rate system, the exchange rate can quickly reflect changes in the market supply and demand relationship, so it can more accurately reflect the actual situation of the international market. This helps to avoid human intervention and maintain the relative stability of the exchange rate.

2. Automatic adjustment mechanism: The floating exchange rate system has an automatic adjustment mechanism. When the domestic economy faces challenges, changes in exchange rates can help countries adjust, such as by resisting inflation or improving export competitiveness.

3. Policy independence: The floating exchange rate system provides greater monetary policy independence for national governments, as the government can independently decide monetary policy without sacrificing other policy objectives to maintain exchange rates.

4. To curb the consumption of foreign exchange reserves: Under a fixed exchange rate system, the government usually needs to maintain a certain level of foreign exchange reserves to support the fixed exchange rate. The floating exchange rate system can reduce this demand and reduce the consumption of foreign exchange reserves.

Disadvantages:

1. Instability: Under a floating exchange rate system, exchange rates may experience significant fluctuations in the short term, which may trigger market uncertainty and make it difficult for businesses and investors to plan for the future.

2. Foreign exchange risk: The floating exchange rate system increases foreign exchange risk, especially for enterprises engaged in international trade or cross-border investment. Exchange rate fluctuations may have adverse effects, such as reducing export competitiveness or increasing import costs.

3. Speculation: A floating exchange rate system may trigger speculative trading, leading to excessive market volatility, which may harm the country's economic stability.

4. Fixed costs: For some countries, maintaining a floating exchange rate system may require more resources and regulatory costs, as the government needs to closely monitor the market and take necessary intervention measures.

5. Lack of long-term stability: Under a floating exchange rate system, exchange rates may lack long-term stability, which may have a negative impact on long-term business plans and international investment decisions.

The Impact of the Floating Exchange Rate System on the International Economy

1. International trade: The floating exchange rate system can promote international trade because it can reflect the market supply and demand situation, making the exchange rate more fair and reasonable. The relative value of currency can freely fluctuate, which helps facilitate business activities between international trading partners.

2. Competitiveness: A floating exchange rate system can help countries adjust the relative value of their currencies to maintain or enhance the competitiveness of domestic industries. When a country's currency appreciates, its exports may be under pressure, but at the same time, imports may become cheaper. This can drive domestic enterprises to improve efficiency and adapt to the international market.

3. Foreign investment: The floating exchange rate system increases the risk for foreign investors, as exchange rate fluctuations may have adverse effects on their investments. This may reduce the attractiveness of some countries, but it can also provide investment opportunities as exchange rate fluctuations can also bring potential high returns.

4. Stability of the foreign exchange market: Under a floating exchange rate system, the foreign exchange market may become more flexible as market participants are more free to buy and sell currencies, but this may also make the market more susceptible to short-term speculative trading interference, leading to increased exchange rate fluctuations.

5. Inflation and Price Stability: A floating exchange rate system can help countries better respond to the challenges of inflation and price stability. When domestic inflation rises, exchange rates may be affected, leading to currency appreciation. This can help curb inflation.

Through the explanation and analysis of the advantages and disadvantages of the floating exchange rate system terms mentioned above, it can be seen that under the floating exchange rate system, market supply and demand determine the changes in the exchange rate, which means that the exchange rate will fluctuate based on transactions in the foreign exchange market and investors' demand for currency and hedging risk. If a country's economic growth is strong and capital inflows increase, it will lead to the appreciation of the country's currency. On the contrary, if a country's economy faces difficulties and capital outflows increase, it will lead to a devaluation of the country's currency.

Disclaimer: This material is for general information purposes only and is not intended as (and should not be considered to be) financial, investment or other advice on which reliance should be placed. No opinion given in the material constitutes a recommendation by EBC or the author that any particular investment, security, transaction or investment strategy is suitable for any specific person.