floating exchange-rate system

Floating exchange-rate systemclick for a larger image
Fig. 74 Floating exchange-rate system. (a) If the UK's imports from the USA rise faster than the UK's exports to the USA, then, in currency terms, the UK's demand for dollars will increase relative to the demand in the USA for pounds. This will cause the pound to fall (see DEPRECIATION 1) against the dollar, making imports from the USA to the UK more expensive and exports from the UK to the USA cheaper. By contrast, if the UK's imports from the USA rise more slowly than its exports to the USA, then, in currency terms, its demand for dollars will be relatively smaller than the US demand for pounds. This will cause the pound to rise (see APPRECIATION 1), making imports from the USA to the UK cheaper and exports from the UK to the USA more expensive. (b) The graph shows how nations can manage the float by intervening in the currency market to buy and sell currencies, using their national currency reserves to moderate the degree of short-term fluctuation and smooth out the long-term trend line.

(c) UK £-US $ exchange rate.

floating exchange-rate system

a mechanism for coordinating EXCHANGE RATES between countries’ CURRENCIES that involves the value of each country's currency in terms of other currencies being determined by the forces of the demand for, and supply of, currencies in the FOREIGN EXCHANGE MARKET. Over time, the exchange rate of a particular currency may rise (APPRECIATION) or fall (DEPRECIATION) depending, respectively, on the strength or weakness of the country's underlying BALANCE OF PAYMENTS position and exposure to speculative activity (see SPECULATOR), as shown in Fig. 74 (a) and (c). (See alsoEURO.) In theory, this should always result in an equilibrium exchange rate (i.e. a rate that ensures that a country achieves a BALANCE OF PAYMENTS EQUILIBRIUM), leaving the country more freedom to pursue desirable domestic policies without external restraints. In practice, however ‘unregulated’, free-floating exchange rates tend to produce erratic and destabilizing exchange rate movements, often fuelled by speculative HOT MONEY flows, which makes it difficult to enter into meaningful trade (EXPORT, IMPORT contracts) and investment transactions (FOREIGN INVESTMENT deals) because of the uncertainties surrounding the profit and loss implications of such deals when exchange rates are fluctuating wildly. For this reason, countries often prefer to ‘manage’ their exchange rates, as shown in Fig. 74 (b), with their CENTRAL BANKS buying and selling currencies, as appropriate, in the foreign exchange market.

While this creates a more settled and controlled environment in which to operate, nonetheless firms are usually forced to cover their currency requirements by, for example, taking out OPTIONS in the FUTURES MARKET (see EXCHANGE RATE EXPOSURE).

Moreover, a country's 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 DEPRECIATION 1 entry for details of the back-up factors that are critical to the ‘success’ of exchange-rate changes in removing payments disequilibriums. Compare FIXED EXCHANGE RATE SYSTEM. See PURCHASING POWER PARITY THEORY, ASSET VALUE THEORY, ADJUSTMENT MECHANISM, INTERNATIONAL MONETARY FUND, FOREIGN EXCHANGE EQUALIZATION ACCOUNT.

Collins Dictionary of Economics, 4th ed. © C. Pass, B. Lowes, L. Davies 2005