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A floating exchange rate is determined by the foreign exchange market and can be volatile, but allows for self-correction. Governments can intervene in a managed floating exchange rate to stabilize the currency. The process is complicated and involves expert economists and political scientists.
A floating exchange rate is an exchange rate that can change in response to market pressures. The exchange value of the currency in question is determined by activities in the foreign exchange market, causing its value to rise and fall. Instead, the government sets a fixed exchange rate, usually by pegging the value of the currency to the value of a monetary unit, such as the United States dollar.
The idea behind a floating exchange rate is that it allows for self-correction. As market pressures change and value rises and falls, the economy should, in theory, remain stable. In practice, things are not that 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 goes into an economic tailspin, having a floating exchange rate can be brutal for citizens as they may find their purchasing power dwindling 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 for the currency in question, economic activities in the nation of origin, and a wide variety of other factors, including general financial depression and similar events.
Most commonly, nations use what is known as a managed floating exchange rate. In this case, the value of the currency is determined in the foreign exchange market, but the government can intervene. For example, if the supply of the currency is excessive, reducing the value, the government can withdraw some of the currency in reserves to limit the supply and therefore increase the demand and value. Similarly, if the exchange rate rises too much in the other direction, foreign exchange reserves can be released to increase supply.
Governments work carefully to manage the exchange rate. They don’t want to interfere too much and create an artificial exchange rate, but they also don’t want to sit on the sidelines and not intervene in the event of a problem. Government officials generally review the situation on a regular basis to decide what actions, if any, they should take to keep the currency as stable as possible. Expert economists and political scientists are usually involved in these decisions, and the process can become very complicated for government representatives.
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