What is a Floating Exchange Rate?
A floating exchange rate refers to changes in a currency's value relative to another currency (or currencies).
How Does a Floating Exchange Rate Work?
Floating exchange ratesthat currencies change in relative value all the time. For example, one U.S. dollar might buy one British Pound today, but it might only buy 0.95 British Pounds tomorrow. The value 'floats.'
The concept of floating exchange rates was not a genuine reality until the Bretton Woods agreement and the International Monetary Fund (IMF) were created to facilitate systems of exchange. Before that, the gold standard, whereby the value of a piece of currency was directly linked to a specific quantity of gold, was the prevalent method of currency valuation around the world.
[Learn more about Bretton Woods in our article about John Maynard Keynes: The Man Who Transformed the Economic World]
In a floating exchange rate system, when the demand for a currency is low, its value decreases just as with any other product or service. But the result of a devalued currency is that imported goods seem more expensive to the people holding that currency. What used to require $5 to buy now requires $10. Because imported goods seem more expensive, people usually start buying more domestic goods, which tends to create jobs and stimulate the economy in general.
However, the opposite is also true. When the currency becomes more valuable, imported items seem cheaper, and suddenly people want to buy fewer domestically produced items. This tends to increase unemployment and slow the economy in general.
Why Does a Floating Exchange Rate Matter?
Activity in the foreign exchange (forex) markets determines the exchange rates for floating currencies because those markets reflect the supply and demand for a particular currency. This is not the case for currencies with fixed exchange rates (often called 'pegged' currencies), where a country's central bank intervenes and stabilizes or regulates the value of the currency by buying and selling its own currency reserves in return for the currency to which it is peg Floating exchange rates create something called exchange rate risk (also called currency risk). This risk is important to foreign investors, because it means that when exchange rates change, the amount of money the investor sees at the end of the day changes too.
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