floating exchange rate system
Floating exchange rate system
Floating Exchange Rate System
floating exchange rate systema mechanism for coordinating EXCHANGE RATES between countries' currencies which involves the value of each country's currency in terms of other currencies being determined by the forces of supply and demand in the FOREIGN EXCHANGE MARKET (see EQUILIBRIUM MARKET PRICE). Over time the exchange rate of a particular currency may rise (appreciate) or fall (depreciate) depending, respectively, on the strength or weakness of its underlying BALANCE OF PAYMENTS position and exposure to SPECULATIVE activity See APPRECIATION, definition 2, DEPRECIATION, definition 2.
Generally speaking, the business and financial community dislikes unregulated floating exchange rates since the market tends to produce erratic and destabilizing exchange rate movements, often prompted by currency speculation, which makes it difficult to conclude meaningful trade and investment transactions, because of the uncertainties surrounding the profit-and-loss implications of such deals when exchange rates are fluctuating widely. Governments too dislike disorderly currency markets and prefer where possible to ‘manage’ their exchange rates both to moderate the excessive short-term fluctuations and to smooth out the underlying longer-term trend line by buying and selling currencies as appropriate out of their foreign exchange equalization account. While this creates a more settled and controlled environment in which to operate, nonetheless firms are usually forced to cover their currency deals in the forward exchange market.
Government intervention in currency markets sometimes goes beyond merely smoothing its exchange rate and may involve a deliberate attempt to manipulate the exchange rate so as to gain a trading advantage over other countries (a so-called dirty float). See FORWARD MARKET, INTERNATIONAL MONETARY FUND, ECONOMIC POLICY, CENTRAL BANK, GROUP OF 7 (G7), PURCHASING POWER PARITY, EXCHANGE RATE EXPOSURE.