Floating exchange rate allows the value of currency to fluctuate according to the foreign exchange market trading. Typically, the currency that uses a floating exchange rate is called floating currency. Under the floating exchange rate principle, the currency value of the country is set according to the supply and demand of the currency in the foreign exchange market. The concept of floating exchange rate is in contrast to that of the fixed exchange rate and it changes freely with the trading in Forex market.
If the value of currency shows some rapid upward or downward movements, the central bank of the country starts buying or selling its own currency in the foreign exchange market.
This practice stabilizes the local currency value. But in case of floating exchange rate regime, the central banks are reluctant to intervene. Hence, the floating exchange rate regimes of currencies are also better known as a managed float. In the extreme cases the central banks generally allow the price of the currency to float in between the lower and upper bounds.
According to many economists the floating exchange rates are more useful than fixed exchange rates. In some economic situations, the fixed exchange rates are preferred for their stability and certainty. Incidentally, there is no country with absolute floating currencies. It can also be said that there is no currency that is entirely determined by the trading of foreign exchange market.
The foreign exchange volatility is increased by the free floating exchange rate. In case of the emerging economy this may create difficulties.
The financial sector in such an economy befits to one or more of the following conditions:
High Liability Dollarization
Strong Balance Sheet Effects
In case of the foreign exchange trade, the liabilities are in the foreign currency while the assets are measured in the local currency. Sudden and unexpected exchange rate depreciation may cause deterioration in the balance sheet thus threatening the domestic financial system stability. Due to this reason the emerging countries face higher fear of floating.
Last Updated on : 1st July 2013