“Floating exchange rate”
A floating exchange rate system determines a currency’s value in relation to other currencies. Unlike fixed exchange rates, these currencies float freely, that is, unrestrained by government controls or trade limits.
Continuous currency volatility
In consequence, floating exchange rates are in continuous fluctuation. Changes in factors such as interest rates, inflation, political stability, trade flows, tourism and speculation, just to name a few, maintain free-floating currencies in continuous movement.
This volatility is perceived as a positive aspect for currency speculators, who account for the vast majority of FX market trading. For companies carrying out business in foreign currencies, however, it poses translation and transaction risks that might seriously impact their profit margins.
Advantages of a floating exchange rate
- Balance of payments stability
Theoretically, imbalances in the balance of payments lead to automatic changes in exchange rates. For instance, a deficit in the balance of payments would trigger currency depreciation. This would make a country’s exports cheaper in foreign markets, increasing their demand and ultimately restoring equilibrium in the balance of payments.
- No restrictions on foreign exchange and capital flows
Unlike with a fixed exchange rate, there are no restrictions to trade with these currencies. Therefore, there is no need for a constant management process on the part of the government or central bank.
- No need to keep large foreign currency reserves
Free-floating exchange rates do not require the monetary issuing authorities to keep large amounts of foreign currency reserves to defend the exchange rate. Those reserves, therefore, can be used to import capital goods to promote economic growth.
- Protection against imported inflation
One of the main problems facing countries with fixed exchange rates is that they may import inflation via higher import prices or via the balance of payments surpluses vis-à-vis deficit countries. Countries with free-floating exchange rates do not have that problem.
Disadvantages of a floating exchange rate
- High level of exposure to exchange rate volatility
By nature, floating exchange rates are volatile and prone to sharp fluctuations. The value of a currency against another can be severely diminished in a single trading day.
- Lack of currency control can curtail economic recovery or growth
Negative exchange rate movements for a country’s currency can create serious problems. For instance, if the pound rises against the euro, it makes exporting to the Eurozone from the UK more difficult.
On the other hand, depreciation of a currency’s value tends to increase inflation. Therefore, a government must be wary of volatility and take measures to promote a stable, growing economy.