Floating Exchange Rate

Under a floating exchange rate, a currency's value is driven chiefly by trading between buyers and sellers in the foreign exchange market, instead of being pinned to a set figure by the government or central bank. The monetary authority may intervene occasionally to calm disorderly market conditions, but it does not commit to defending a particular level or band. Floating regimes are the opposite end of the spectrum from a currency peg or currency board, and they are used today by most large advanced economies.

The US dollar, the euro, the Japanese yen, the British pound, the Swiss franc, the Canadian dollar and the Australian dollar are among the major currencies whose exchange rates float.

For most of the nineteenth and early twentieth centuries, major currencies were tied to gold under the gold standard. After the Second World War, the Bretton Woods system fixed currencies to the US dollar, which was in turn convertible into gold for foreign official holders. That system broke down after the United States suspended gold convertibility in August 1971, and by March 1973 the major currencies were floating against each other. The Jamaica Accords of 1976, given effect by the Second Amendment to the IMF's Articles of Agreement in 1978, formally allowed members to choose their own exchange arrangements. Some countries floated earlier; Canada, for example, floated its dollar in the 1950s and again from 1970.

Under a float, the exchange rate moves continuously as banks, companies, investors and individuals buy and sell currencies. Demand for a currency rises when foreigners want to buy the country's exports or assets, and falls when residents import more or invest abroad. Interest rate differentials, inflation expectations, the current account balance, capital flows, risk sentiment and speculation all influence the spot rate.

Because the central bank is not defending a level, it is free to set interest rates for domestic goals such as controlling inflation. This reflects the impossible trinity: a country cannot simultaneously have a fixed exchange rate, free capital movement and an independent monetary policy. Floating countries choose the last two.

The International Monetary Fund classifies regimes by actual behavior rather than official declarations. Its categories include:

• Free floating: intervention is rare, limited to exceptional circumstances, and documented.
• Floating: the rate is largely market-determined, but the central bank intervenes more often, sometimes to smooth movements.
• Managed float: a common informal term for floating regimes with frequent intervention or use of capital controls, which can shade into a soft peg.

Many emerging market currencies officially float while their central banks intervene heavily, a pattern economists have described as "fear of floating." Such countries often hold large foreign exchange reserves to manage volatility, and the adequacy of those reserves is a recurring policy question.

Supporters argue that floating rates act as a shock absorber. If demand for a country's exports falls, its currency weakens, making exports cheaper and helping the economy adjust without wage cuts or unemployment. A float also removes the risk of a speculative attack on a fixed rate, as when the United Kingdom was forced out of the European Exchange Rate Mechanism in September 1992.

The disadvantages include volatility that can complicate trade and investment decisions, the possibility of overshooting well beyond fundamentals, and the pass-through of depreciation into import prices and inflation. Countries with large foreign-currency debts, a situation sometimes linked to partial dollarization, may suffer balance sheet damage when their currency falls sharply, which is one reason some prefer a peg.

For firms moving money across borders, a floating rate means that the cost of a payment can change between quotation and settlement. Businesses manage this through hedging with instruments such as a forward contract or an FX swap, or through a natural hedge in which revenues and costs share the same currency. Payment providers quoting fixed rates to customers carry the risk of rate movements during the time money is in transit, and price that risk into their FX markup. Under a free float, the mid-market rate is a transparent reference; under managed regimes or controls, official and parallel rates may diverge.