floating exchange-rate system
floating exchange-rate systema 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.