Floating Exchange Rate - Flexible Exchange Rate

By: EconomyWatch   Date: 23 November 2010

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A floating exchange rate is a type of an exchange rate regime. It is also called the flexible exchange rate. In case of a floating exchange rate, the value of a currency keeps on fluctuating in accordance with the movements of the foreign exchange market.

The floating exchange rate is the opposite of the fixed exchange rate. Certain economic experts are of the opinion that a floating exchange rate is more preferable than a fixed exchange rate. This is because they are adept at absorbing the aftereffects of critical financial crises.

Canada is perhaps the one country, where the value of the national currency is determined by the movements of the foreign exchange market. If there is a situation where the economic balance is found to be disturbed, the central bank of the particular country comes in to salvage the situation and the floating rate is somehow kept operational. Such cases are also called managed floats.

In such cases the bank fixes a “floor” and a “ceiling”, i.e., a lower and an upper limit between which the exchange rate keeps on moving. They either buy or sell significant amounts of foreign exchange reserves in order to provide a certain amount of support to the domestic currencies. However, the chances of such occurrences are very low.
Floating exchange rate is also known to be self correcting. This is because it has been seen that if there is any imbalance between the demand and supply, the floating exchange rate will adjust itself with the market conditions. There are certain negative aspects of the floating exchange rates. It has been observed that the floating exchange rates increase the levels of volatility in the foreign exchange scenario. Such issues have an adverse impact on the economic state of countries and this is especially applicable for those countries that have emerging economies.

Most often it has been observed that these emerging countries have certain typical conditions – they have substantial amounts of debt dollarization, the impact of the balance sheet is pretty strong and the state of the economy is pretty unstable, to say the least. It has been observed that if the liabilities of a country are denominated in a foreign currency and the properties are in domestic currency, any unaccounted degradation in the value of the domestic currency is expected to result in severe financial crisis that is enough to destabilize the economy.

This is precisely the reason as to why a big number of the emerging economies find it very difficult to exercise floating rates. They also have shorter basic exchange rates and still experience more problems with the rates of interest and the movements of the financial reserves. All this compounds the problem for these smaller countries with emerging economies.


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