A floating exchange rate or fluctuating exchange rate is a type of exchange rate regime The exchange rate regime is the way a country manages its currency in respect to foreign currencies and the foreign exchange market. It is closely related to monetary policy and the two are generally dependent on many of the same factors wherein a currency In economics, the term currency can refer to a particular currency, for example Pound Sterling, or to the coins and banknotes of a particular currency, which comprise the physical aspects of a nation's money supply. The other part of a nation's money supply consists of money deposited in banks , ownership of which can be transferred by means of's value is allowed to fluctuate according to the foreign exchange market The foreign exchange market is a worldwide decentralized over-the-counter financial market for the trading of currencies. Financial centers around the world function as anchors of trading between a wide range of different types of buyers and sellers around the clock, with the exception of weekends. A currency that uses a floating exchange rate is known as a floating currency A floating currency is a currency that uses a floating exchange rate as its exchange rate regime. A floating currency is contrasted with a fixed currency. It is not possible for a developing country to maintain the stability in the rate of exchange for its currency in the exchange market. There are two options open for them- [1] Let the exchange rate be allowed to fluctuate in the open market according to the market conditions, or [2] An equilibrium rate may be fixed to be adopted and attempts should be made to maintain it as far as possible. But, if there is a fundamental change in the circumstances, the rate should be changed accordingly. The rate of exchange under the first alternative is know as fluctuating rate of exchange and under second alternative, it is called flexible rate of exchange. In the modern economic conditions, the flexible rate of exchange system is more appropriate as it does not hamper the foreign trade. There are economists An economist is a professional in the social science discipline of economics. The individual may also study, develop, and apply theories and concepts from economics and write about economic policy. Within this field there are many sub-fields, ranging from the broad philosophical theories to the focused study of minutiae within specific markets, who think that, in most circumstances, floating exchange rates are preferable to fixed exchange rates. As floating exchange rates automatically adjust, they enable a country to dampen the impact of shocks In economics a shock is an unexpected or unpredictable event that affects an economy, either positively or negatively. Technically, it refers to an unpredictable change in exogenous factors -- that is, factors unexplained by economics -- which may have an impact on endogenous economic variables and foreign business cycles The term business cycle refers to economy-wide fluctuations in production or economic activity over several months or years. These fluctuations occur around a long-term growth trend, and typically involve shifts over time between periods of relatively rapid economic growth (expansion or boom), and periods of relative stagnation or decline (, and to preempt the possibility of having a balance of payments crisis. However, in certain situations, fixed exchange rates may be preferable for their greater stability and certainty. This may not necessarily be true, considering the results of countries that attempt to keep the prices of their currency "strong" or "high" relative to others, such as the UK or the Southeast Asia countries before the Asian currency crisis The Asian Financial Crisis was a period of financial crisis that gripped much of Asia beginning in July 1997, and raised fears of a worldwide economic meltdown due to financial contagion. The debate of making a choice between fixed and floating exchange rate regimes is set forth by the Mundell-Fleming model The Mundell-Fleming model is an economic model first set forth by Robert Mundell and Marcus Fleming. The model is an extension of the IS-LM model. Whereas the traditional IS-LM Model deals with economy under autarky , the Mundell-Fleming model tries to describe an open economy, which argues that an economy cannot simultaneously maintain a fixed exchange rate, free capital movement, and an independent monetary policy. It can choose any two for control, and leave third to the market forces.
In cases of extreme appreciation or depreciation, a central bank A central bank, reserve bank, or monetary authority is a banking institution granted the exclusive privilege to lend a government its currency. Like a normal commercial bank, a central bank charges interest on the loans made to borrowers, primarily the government of whichever country the bank exists for, and to other commercial banks, typically as will normally intervene to stabilize the currency. Thus, the exchange rate regimes of floating currencies may more technically be known as a managed float. A central bank might, for instance, allow a currency price to float freely between an upper and lower bound, a price "ceiling" and "floor". Management by the central bank may take the form of buying or selling large lots in order to provide price support or resistance, or, in the case of some national currencies, there may be legal penalties for trading outside these bounds.
Fear of floating
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A free floating exchange rate increases foreign exchange volatility. There are economists who think that this could cause serious problems, especially in emerging economies. These economies have a financial sector with one or more of following conditions:
- high liability dollarization
- financial fragility
- strong balance sheet effects
When liabilities In financial accounting, a liability is defined as an obligation of an entity arising from past transactions or events, the settlement of which may result in the transfer or use of assets, provision of services or other yielding of economic benefits in the future are denominated in foreign currencies while assets are in the local currency, unexpected depreciations of the exchange rate deteriorate bank and corporate balance sheets and threaten the stability of the domestic financial system.
For this reason emerging countries appear to face greater fear of floating, as they have much smaller variations of the nominal exchange rate, yet face bigger shocks and interest rate and reserve movements.[1] This is the consequence of frequent free floating countries' reaction to exchange rate movements with monetary policy Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting a rate of interest. Monetary policy is usually used to attain a set of objectives oriented towards the growth and stability of the economy. These goals usually include stable prices and low unemployment. Monetary theory and/or intervention in the foreign exchange market The foreign exchange market is a worldwide decentralized over-the-counter financial market for the trading of currencies. Financial centers around the world function as anchors of trading between a wide range of different types of buyers and sellers around the clock, with the exception of weekends.
The number of countries that present fear of floating increased significantly during the nineties.[2]
References
- ^ Calvo, G., and Reinhart, C. (2002). "Fear of Floating." Quarterly Journal of Economics, 117: 379-408.
- ^ Levy-Yeyati, E. and F. Sturzenegger (2004). "Classifying Exchange Rate Regimes: Deeds vs. Words." European Economic Review.
Categories: Foreign exchange market Categories: Currency | International finance | Financial markets | Orex Trading
