What Is a Floating Exchange Rate?

What Is a Floating Exchange Rate?

A floating exchange rate is a regime where the currency price of a nation is set by the forex market based on supply and demand relative to other currencies. This is contrary to a fixed exchange rate, in which the government entirely or predominantly determines the rate.

Floating vs. Fixed Exchange Rates

Floating exchange rate systems mean long-term currency price changes reflect relative economic strength and interest rate differentials between countries. Currency prices can be determined with a floating rate or a fixed rate.

A floating rate is based on supply and demand in the open forex market. If the demand for the currency is high, the value will increase. If demand is low, this will drive that currency price lower. The currencies of most of the world's major economies were allowed to float freely following the collapse of the Bretton Woods system between 1968 and 1973.

Central banks determine fixed or pegged rates. The rate is set against another major world currency such as the U.S. dollar, euro, or yen. The government will buy and sell its currency against the pegged currency. Some countries peg their currencies to the U.S. dollar including Jordan and the United Arab Emirates. 

Bretton Woods Conference

The Bretton Woods Conference established a gold standard for currencies in July 1944. A total of 44 countries met, with attendees limited to the Allies in World War II. The Conference established the International Monetary Fund (IMF) and the World Bank, setting guidelines for a fixed exchange rate system.

A gold price of $35 per ounce was established, with participating countries pegging their currency to the dollar. Adjustments of plus or minus 1% were permitted. The U.S. dollar became the reserve currency through which central banks could adjust or stabilize rates.

The first large crack in the system appeared in 1967, with a run on gold and an attack on the British pound that led to a 14.3% devaluation. President Richard Nixon removed the United States from the gold standard in 1971.By 1973, the system had collapsed, and participating currencies were allowed to float freely.

Currency Intervention

Short-term moves in a floating exchange rate currency reflect speculation, rumors, disasters, and everyday supply and demand for the currency. If supply outstrips demand that currency will fall, and if demand outstrips supply that currency will rise. Central banks may buy or sell local currencies to adjust the exchange rate in a floating rate system to stabilize a volatile market or achieve a rate change.

A currency that is too high or too low can affect a nation's economy, affecting trade and the ability to pay debts. The government or central bank will attempt to implement measures to move their currency to a more favorable price. Groups of central banks, such as those of the G-7 nations (Canada, France, Germany, Italy, Japan, the United Kingdom, and the United States), often work together in coordinated interventions.

A prominent example of a failed intervention occurred in 1992 when financier George Soros spearheaded an attack on the British pound. The currency entered the European Exchange Rate Mechanism (ERM) in Oct. 1990; the ERM was designed to limit currency volatility as a lead-in to the euro, which was still in the planning stages.The Bank of England was forced to devalue the currency and withdraw from the ERM. The failed intervention cost the U.K. Treasury a reported £3.3 billion. Soros made over $1 billion.

The Bottom Line

Floating exchange rates are primarily how most currencies are valued. This means the value of a currency is based on supply and demand. This contrasts with other methods, such as the value of a currency based on the value of certain assets it holds, historically gold, or a country deciding to fix or peg its currency.