Floating Exchange Rate

A floating exchange rate or fluctuating exchange rate is a type of exchange rate regime wherein a currency's value is allowed to fluctuate according to the foreign exchange market. A currency that uses a floating exchange rate is known as a floating currency. It is not possible for a developing country to maintain the stability in the rate of exchange for its currency in the exchange market. There are two options open for them-  Let the exchange rate be allowed to fluctuate in the open market according to the market conditions, or  An equilibrium rate may be fixed to be adopted and attempts should be made to maintain it as far as possible. But, if there is a fundamental change in the circumstances, the rate should be changed accordingly. The rate of exchange under the first alternative is know as fluctuating rate of exchange and under second alternative, it is called flexible rate of exchange. In the modern economic conditions, the flexible rate of exchange system is more appropriate as it does not hamper the foreign trade. There are economists who think that, in most circumstances, floating exchange rates are preferable to fixed exchange rates. As floating exchange rates automatically adjust, they enable a country to dampen the impact of shocks and foreign business cycles, and to preempt the possibility of having a balance of payments crisis. However, in certain situations, fixed exchange rates may be preferable for their greater stability and certainty. This may not necessarily be true, considering the results of countries that attempt to keep the prices of their currency "strong" or "high" relative to others, such as the UK or the Southeast Asia countries before the Asian currency crisis. The debate of making a choice between fixed and floating exchange rate regimes is set forth by the Mundell-Fleming model, which argues that an economy cannot simultaneously maintain a fixed exchange rate, free capital movement, and an independent monetary policy. It can choose any two for control, and leave third to the market forces.

In cases of extreme appreciation or depreciation, a central bank will normally intervene to stabilize the currency. Thus, the exchange rate regimes of floating currencies may more technically be known as a managed float. A central bank might, for instance, allow a currency price to float freely between an upper and lower bound, a price "ceiling" and "floor". Management by the central bank may take the form of buying or selling large lots in order to provide price support or resistance, or, in the case of some national currencies, there may be legal penalties for trading outside these bounds.