What is a Floating Exchange Rate?

A floating exchange rate is an exchange rate which is allowed to shift in response to market pressures. The exchange value of the currency in question is determined by activities on the foreign exchange market, causing its value to rise and fall. By contrast, a fixed exchange rate is set by the government, usually by pinning the value of the currency to the value of a currency unit such as the United States dollar.

The idea behind a floating exchange rate is that it allows for self correction. As market pressures shift and the value rises and falls, the economy should in theory remain stable. In practice, things are not this simple. While many nations use a floating exchange rate, the rate can be highly volatile, and can have a profound impact on local economies. Especially if a nation enters an economic tailspin, having a floating exchange rate can be brutal for the citizens, as they may find that their purchasing power dwindles away to nothing.

In a truly independent floating exchange rate, the value of the currency is determined solely on the foreign exchange market. It changes in response to supply and demand of the currency in question, economic activities in the nation of origin, and a wide variety of other factors, including overall financial depression and similar events.

More commonly, nations use what is known as a managed floating exchange rate. In this case, the currency's value is determined on the foreign exchange market, but the government can intervene. For example, if the supply of the currency is excessive, driving the value down, the government can recall some of the currency into reserves to limit the supply and thereby increase the demand and value. Likewise, if the exchange rate climbs too high in the other direction, currency reserves can be released to increase the supply.

Governments work carefully to manage the exchange rate. They do not want to interfere too much and create an artificial rate of exchange, but they also do not want to stand on the sidelines and fail to intervene in the event of a problem. Government officials usually review the situation on a regular basis to decide which actions, if any, they need to take to keep the currency as stable as possible. Usually skilled economists as well as political scientists are involved in these decisions, and the process can become very complicated for government representatives.