Floating exchange rate definition

What is a floating exchange rate?

A floating exchange rate refers to a currency where the price is determined by supply and demand factors relative to other currencies. A floating exchange rate is different to a fixed – or pegged – exchange rate, which is entirely determined by the government of the currency in question.

How do floating exchange rates work?

Floating exchange rates work through an open market system in which the price is driven by speculation and the forces of supply and demand. Under this system, increased supply but lower demand means that the price of a currency pair will fall; while increased demand and lower supply means that the price will rise.

Floating currencies are perceived as strong or weak depending on the market sentiment towards their country’s economy. For example, if a government is viewed as unstable, the currency is likely to depreciate as faith in their ability to regulate the economy declines.

However, governments can intervene in a floating exchange rate to keep their currency’s price at a favourable level for international trade – this also helps to avoid manipulation by other governments.

Floating exchange rate vs fixed exchange rates

Floating exchange rates are seen as fairer, freer and more efficient when compared to fixed rate systems. Pegged currencies are thought of as more rigged, and their prices tend to fluctuate in a much narrower range.

However, fixed exchange rates can be advantageous in times of economic uncertainty when the markets are unstable. Developing countries and economies also often peg their currencies – often to the US dollar – as the increased stability provided could encourage investment and result in lower inflation rates.

Example of government intervention in exchange rates

The Chinese government – through the Peoples’ Bank of China (PBOC) – regularly intervenes in exchange rates to keep the yuan undervalued. It does this to depreciate the value of the yuan which makes exports cheaper – with the yuan being pegged to a basket of currencies in order to achieve this.

The basket of currencies is dominated by the US dollar, and the PBOC attempts to keep the yuan within a 2% trading band around the US dollar. The PBOC achieves this through buying up other currencies – or sometimes US treasury bonds – and issuing more yuan back into the market. In doing so, it increases the supply of yuan while restricting the supply of other currencies.