Last Updated on Feb 10, 2022 by Ayushi Mishra
You might have heard or read about the Indian National Rupee (INR) appreciating or depreciating against the US dollar’s value. There is an exchange rate against international currencies. This is the rate at which you can buy such international currencies by paying in Indian currency. These exchange rates can be either fixed or floating.
Usually, most countries follow the floating exchange rate system based on which their currencies are valued against other currencies. But what exactly is this floating exchange rate?
This article covers:
- The concept of floating exchange rate
- How does the floating exchange rate work?
- The difference between the fixed and floating exchange rate
- Benefits of the floating exchange rate
- Drawbacks of the floating exchange rate
Table of Contents
The concept of floating exchange rate
The floating exchange rate is a mechanism to determine the exchange rate between two or more currencies. Under this system, the value of a currency is determined based on the demand and supply of the currency against other currencies in the foreign exchange market. Thus, under the floating exchange rate, the price of a currency against other currencies is not determined by the government but by external market forces.
How does the floating exchange rate work?
The main basis to determine the exchange rate of a currency, under the floating exchange rate system, is the demand and supply of the currency. Here’s how the price mechanism of demand and supply affects the exchange rate of a currency:
In the above diagram, this is how the exchange rate of a currency would change:
Change in the exchange rate due to change in demand: If the demand of the currency increases and moves from D1 to D2, while the supply remains constant at S1, the currency would appreciate. Contrary to this, if the demand falls from D2 to D1 while the supply remains constant at S1, the currency would depreciate.
Change in the exchange rate due to change in supply: If the supply of the currency increases and moves from S1 to S2 while the demand remains the same at D1, the currency would depreciate. On the other hand, if the supply falls from S2 to S1 while the demand remains constant at D1, the currency would appreciate.
Besides the changes in the supply and demand of the currency in international markets, the exchange rate also depends on the socio-political state of a country. If the country’s socio-political state is unstable or at times in crisis, the currency depreciates. On the other hand, if the country is perceived to be economically stable, the currency appreciates.
Thus, the floating exchange rate determines the value of a currency in international markets based on external factors, not controlled by the government of the country. However, the government can intervene to stabilize the exchange rates of its currencies, if required, even if the currency follows the floating exchange rate system.
The difference between the fixed and floating exchange rate
In case of a fixed exchange rate system, the government of a country determines the exchange rate of its currency against another major currency like the US Dollar, British Pound, and the like. Thereafter, to maintain the fixed exchange rate, the government buys or sells the currency against another currency to which the country’s currency is pegged. For example, if a currency is pegged against the US Dollar, to maintain the exchange rate, the government would buy or sell the US Dollar using its currency. China is an example of a country that uses the fixed exchange rate system to determine its currency’s exchange rate.
The floating exchange rate, on the other hand, does not involve the government deciding the exchange rates. It is fixed by open market factors and the global economic perception of the country. Major economies of the world like India, the USA, and Japan follow the floating exchange rate system.
Benefits of the floating exchange rate
The floating exchange rate system has its fair share of advantages which is the reason why most countries follow this method to value their currencies in international markets. Some of the main benefits of the floating exchange rate are as follows:
Ease of trading: Currencies following the floating exchange rate system can be traded easily, without any restrictions. This fosters the development of international trade which proves economically viable for countries.
Stabilising the Balance of Payments (BOP): Countries engaging in international trade use a BOP to record their international transactions. Any surplus or deficit in the BOP automatically affects the exchange rate. Changes in the exchange rate, in turn, affect the demand and supply of the currency which, in turn, stabilises the BOP.
For example, say the BOP has a surplus. This is favourable, resulting in the currency appreciating. As the currency appreciates, imports become cheaper. This increases the supply of the currency, causing the currency to depreciate again thereby eliminating the surplus and equalizing the BOP.
Better economic management of the country: Since the exchange rate is not determined and managed by the government, it does not need to hold large reserves of foreign currency to manipulate the exchange rate. This allows the government to use the surplus funds to promote the economic development of the country.
Drawbacks of the floating exchange rate
There are certain limitations too that are associated with the floating exchange rate system. You need to see this side of the coin too to understand the whole concept of such a system. So, have a look:
High volatility: Exchange rates of currencies fluctuate considerably and are highly volatile. They can change within seconds, which is why you need to factor in the volatility if you are trading in foreign currencies.
Economic impact: If the government does not control the exchange rate, it might prove to be a hindrance to economic growth. A consistently depreciating currency would make imports expensive thereby affecting the foreign trade adversely.
Enhanced adversity: If a country is experiencing a recession or a bad economic trend, the depreciating current value would only add to its woes worsening the situation further.
The floating exchange rate is the basis of determining the exchange rate of the Indian currency against other currencies. It impacts the value of the INR on a daily basis and if you want to understand why the exchange rates are fluctuating, you need to understand how the floating exchange rate works. Understanding the concept of floating exchange rate and its pros and cons helps develop a better understanding of how foreign exchange works.