Floating Exchange Rate

How is a floating exchange rate determined?

Simply put, free-market forces determine the value of a floating exchange rate. However, the main free market determinants are:

1. Trade
2. Investment
3. Speculation

Let’s look at an example for each main market determinate using the United States Dollar (USD) as our base currency.

Trade

Let’s imagine that the USA’s small to medium enterprise exports rise by 60% and that China is its top buyer this year.

How will this impact the USD?

Figure 1 below illustrates this for us.

Fig 1. - Exchange rate $ to ¥

More US exports will be sold to China. This increase in demand for US exports will also increase the demand for US dollars. This is why the demand curve shifts outwards from D₁ to D_2. The exchange rate of US dollars to the Chinese Yuan rises, so the US dollar appreciates.

Investment

Imagine that Nigeria attracts $40 billion (USD) in foreign direct investment (FDI).

Figure 2 illustrates the impact on the USD.

Fig 2. - Exchange rate $ to ₦

Remember that for Nigeria, it is an inflow of $40 billion while for the US it is an outflow. Because of this, the supply for US dollars increases, thus the supply curve shifts outward from S₁ to S₂. This leads to a depreciation of the US dollar.

Speculation

Let’s imagine that the US is having an election and people believe that due to the uncertainty, the US dollar is going to fall in value.

Figure 3 illustrates the impact on the USD.

Fig 3. - Exchange rate of $

Due to this speculation, investors will avoid buying the dollar. This causes the demand for the dollar to fall from D₁ to D₂. Investors will sell the dollar and this increases the supply of US dollars in the money market, so the supply curve shifts from S₁ to S₂. Due to the fall in demand and increase in supply, there is a double shift with both curves: the demand curve shifts inwards, whilst the supply curve shifts outwards. This results in a depreciation of the US dollar.

Fluctuation in the free market forces and the floating exchange rate

As we know, a floating exchange rate is determined by free-market forces. However, these forces are based on demand and supply which can fluctuate at any moment.

Some fluctuations in the free market that can influence a floating exchange rate are:

• Inflation rates: higher inflation rates make a country's exports less price competitive in comparison to other countries. Exports will fall and imports will rise. Demand for a country's currency will fall and its supply will increase, thus its currency will depreciate.
• Interest rates: high interest rates lead to 'hot money inflows'. This means that investors will exchange their currency for that of the country with higher interest rates because they gain more investment returns. All of this leads to increasing demand for that currency. Supply will fall, causing an appreciation of that currency.
• Economic growth: economic growth will cause an appreciation in a currency. This is because markets will expect interest rates to rise when a country is experiencing rapid growth. Higher interest rates lead to hot money flows that increase demand for a currency.
• Government and other authorities: fluctuations in the exchange rate could also happen due to the central bank or the government buying and selling currency. When they sell their currency, they increase the supply of that currency causing it to depreciate. Appreciation of their currency occurs when they buy their currency back. This only applies to a managed exchange rate, as governments won't intervene if they have a floating exchange rate.

Countries with a floating exchange rate

From past examples in this article, we know that the US has a floating exchange rate. Some other countries with a floating exchange rate are:

• Australia - AU dollar (AUD)
• Canada - CA dollar (CAD)
• Japan - JP yen (JPY)
• Chile - Chilean pesos (CLP)
• Mexico - Mexican pesos (MXN)

Countries are free to adopt whichever system works better for their macroeconomic policy planning. Sometimes, countries move from one system to the other as they grow or change the course of their economic planning.

Advantages of a floating exchange rate

Many countries and governments opt for a floating exchange rate for many different reasons. Some of the advantages of that system are:

• Partial correction for a current account deficit. Due to the frequent changes in the free market, a currency doesn't stay over- or under-valued for long. With an overvalued rate, exports become uncompetitive and market forces adjust the rate by pushing it downwards and towards a new equilibrium. Likewise, an undervalued rate is adjusted by being pushed upwards.
• No government effort or intervention. Governments and central banks don't have to intervene to fix the exchange rate. In free float, exchange rates respond, self-correct, and reach equilibrium automatically. This frees the governments to focus their resources on achieving other economic objectives.
• Freedom to set monetary policy interest rates. A floating exchange rate system operates independently. This means that the events of the world have less weight and resources can be freed up to focus more on the domestic economy.

  In a fixed exchange rate system, interest rates are established for keeping the exchange rates fixed rather than due to their impacts on the local economy.

• Reduces large currency reserves. Governments and central banks don't need to hold large amounts of currency reserves to buy back or sell their currency. The cost of holding these reserves are very expensive so the government can use this money elsewhere in the economy.

Disadvantages of a floating exchange rate

The floating exchange rate system has some disadvantages too. Some of them are:

• Volatility. The free market is prone to sharp fluctuations and this also impacts a floating exchange rate. These fluctuations can wipe out the value of a currency in a single day. Because of how volatile it can be, investors might stay clear of these currencies. Deterring investment can severely impact a country's economic growth and development.

• Instability. Due to internal and external factors, such as speculation, there is no guarantee that a floating exchange rate will be stable. This instability in a currency can impact both consumer and business confidence which will ultimately lead to lower consumption and investment which will restrict economic growth.

• Doesn't correct a current account deficit. One advantage of a floating exchange rate was that it was a partial correction for a currency account deficit. However, this only holds true if the Marshall Lerner condition holds true. If this condition is not met, then a current account deficit will not be corrected automatically.