Investing > How a Floating Exchange Rate Works

How a Floating Exchange Rate Works

Floating exchange rates affect a currency’s fluctuations—meaning they play a big role in trading forex.

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Updated February 11, 2022

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Would you rather be floating in a lazy river at a waterpark, or down an actual mountain stream? 

Each offers its own advantages. A lazy river is highly predictable: even if you don’t totally know what its path is, you know that the water park czars (we don’t know who wields authority at water parks) have put thought into its path, temperature, and chemical makeup (hopefully). On the other hand, floating down an actual river brings fun and adventure—just watch out for those rocks.

If you’re thinking we took the word “floating” and ran with it – you’re not wrong! But, this also illustrates the differences in how exchange rates are constructed. While a fixed exchange rate is determined by a bunch of guys who run waterparks, a floating exchange rate is all free market, all the time

If you’re trading forex, it’s important to understand how exchange rates are set. When you’re investigating how inflation causes the U.S. Dollar to slump after it reached 7% YoY in December 2021, it’s important to understand how government policies impact your day-to-day trading.

So, with that said—let’s… (you guessed it) dive in! 🤿

What you’ll learn
  • What is a Floating Exchange Rate?
  • How to Determine Floating Exchange Rate?
  • Floating vs. Fixed Exchange Rates
  • The Benefits of Floating Exchange Rates
  • Negatives of Floating Exchange Rates
  • Conclusion
  • FAQs
  • Get Started with a Forex Broker

What is a Floating Exchange Rate? 📙

You see, when they build a lazy river – no just kidding, we’re getting into the actual forex stuff now, we promise. A floating exchange rate is not something you do on an inner tube. Instead, it refers to a currency rate that’s determined based on supply and demand. 

In the economy of the United States, the price of most things are set by supply and demand, though incentive program, taxes, and other things can play a role. But this is not always true of currency prices: these can be determined by the market, or they can be set by governmental institutions. The latter are called fixed exchange rates. 

Fixed exchange rates used to be the norm across the globe. In 1944 (stick with us – we promise this history lesson will be brief!), 44 countries attended the Bretton Woods Conference and formed the World Bank. They decided to fix the price of gold at $35 an ounce, and then tie the value of other countries’ currency to the dollar, which also served as the reserve currency. But after the Bretton Woods system fell apart from 1968-1973, floating exchange rates came back into fashion. However, some currencies, like Saudi Arabia’s, are still tied to the U.S. Dollar, though this is the subject of renewed debate since the drop in oil prices following the omicron variant.

If you’re trading currency at all, but particularly if you’re working with the exotic currency pairs that might have highly individualized conditions impacting their rates, it’s important to understand how that rate is being set. Are you investing in a lazy river or a mountain stream?   

How Are Floating Exchange Rates Determined? 📊

Unless you’re a complete forex beginner, you probably have some idea of what affects currency rates. Political upheaval and national economies can impact exchange rates, as can inflation and interest rates, which are set by national governments. Some currencies, such as commodity currencies, are closely tied to the prices of key national exports such as oil or agriculture.

Currency Price Factors

With a floating currency rate, the market ultimately decides the currency’s value. If a whole lot of traders and investors want the currency, its rate will increase – and vice versa. The demand for a currency will be impacted by things like the strength of the country’s economy, and interest rates that might enable investors and lenders to get a better deal by working in a different currency—which is also called carry trading

While fixed exchange rates and floating exchange rates are the two opposite ends of the spectrum, this isn’t exactly a binary where a currency is either fixed or floating. There’s plenty of gray area – for example, ever heard of a little something called the euro? That was the beautiful brainchild of the European Monetary Union. Monetary unions are areas encompassing multiple countries that all agree to one monetary policy. There might still be multiple currencies, but they share a central bank and require agreements on changes to exchange rates. 

Even when central banks don’t directly control the exchange rate, they do make decisions that can impact the value of a currency. For example, Turkey’s central bank cut interest rates even after their currency crashed, and India’s forex reserves will soon be challenged by their record $256 billion in international debt. 

Whether those exchange rates are fixed or floating, the economic actions of national governments have far-reaching consequences. Still, the issue of a central bank’s specific actions are not quite the same as the system of rules and regulations required to keep an exchange rate fixed. To understand this, let’s dive into the specific differences between floating and fixed exchange rates.

Floating vs. Fixed Exchange Rates ⚔

Let’s get a deeper understanding of fixed exchange rates and how they really differ from floating exchange rates. Fixed exchange rates are sometimes called pegged exchange rates, and generally have narrower fluctuations and more restrictions than floating exchange rates.

A floating exchange rate is essentially the “free market” approach. However, fixed exchange rates can protect a currency through unstable markets caused by economic turmoil. Fixing a currency to the U.S. Dollar can bring stability to a developing country, which can be badly needed. 

So what countries have what type of exchange rate? If we’re seeing Russia’s huge spike in inflation in 2021, can we draw any conclusions from how they manage their exchange rate? And are there any basic categories we can establish between floating and fixed exchange rates? 

The United States, Canada, Japan, the UK, the European Union (all major currencies) have free floating exchange rates. Some countries use the U.S. Dollar as their anchor currency: these include Hong Kong, Aruba, Panama, Saudi Arabia, Jordan, and others. Other countries use the Euro: these include Cameroon, Chad, Denmark, Mali, and Senegal. 

The important distinction here is that we’re seeing major currencies choosing a floating rate. This may also be because these nations tend to have larger economies that are less prone to instability from factors outside their control. In other words, why would the United States fix its exchange rate to another currency, when it is the anchor currency for so many other nations that view the Dollar as a more stable currency? 

We can see that a fixed exchange rate is more common in exotic currencies and developing nations. This is because the stabilizing influence of a fixed exchange rate can be incredibly helpful for these nations.

At a glance, the essential differences between fixed exchange rates and floating exchange rates are:

Fixed RateFloating Rate
Usually anchored to another currency (typically a larger economy)Determined by supply and demand for the currency in the global market
Restricts the currency’s value fluctuation, both restricting free market but also providing stability in unstable markets Fewer restrictions but potentially more fluctuation

The Benefits of Floating Exchange Rates 🌟

Now that we have a better understanding of fixed exchange rates, let’s swim back over to our floating exchange rates. These come with their own sets of advantages and disadvantages. Other than getting to shout “yay for the free market” at our weekly capitalism parties (is everyone still going to those?), what exactly is the benefit of a floating exchange rate? 

Unrestricted Trading 🛡

Sometimes a fixed rate can mean that you’re only allowed to trade so much of a certain currency. They have to keep supply and demand in check somehow, right? In a floating exchange, no one is managing the in and out. This also means that portfolios are more free to move between markets.

Balance of Payments Stabilize ⚖

A balance of payments (BOP) refers to the full list of transactions made between a country and all the other countries over a certain period of time. An imbalance BOP might change the exchange rate: if there’s a deficit in the imbalance, the currency might depreciate. But with a floating exchange rate, the market can take care of that by increasing demand for the currency thanks to the lower rates, which in turn will bring the currency value back to its original place. 

Similarly, a country with a fixed rate might accidentally suffer from inflation in another country due to their balances. The top forex brokers will provide varied access to such figures, which emphasizes the importance of using a trusted forex trading platform.

No Need for Large Foreign Exchange Reserves 💰

Central banks in countries with a fixed exchange rate have to keep large reserves. These reserves allow them to maintain their rate during unstable times. Countries with a floating exchange rate do not have this problem, so their reserves can be used for other things. 

Negatives of Floating Exchange Rates 🚧

While a floating exchange rate comes with many benefits, it also has its share of drawbacks. Let’s dive into these to understand why certain nations would choose to have fixed exchange rates instead. 

Instability 📉

The primary purpose of a fixed exchange rate is to promote economic stability – so it’s no shocker that a floating exchange rate exposes an economy to more instability. These currencies will fluctuate and be more volatile in the short term. Restricted Economic Growth 

Say a country’s unemployment spikes. That’s generally not seen as a good thing. This might cause traders to pull out of a currency, assuming it will drop in value – and this causes it to drop in value. So, existing economic problems can get exacerbated, and negative image and fears can impact a nation’s entire economy. 

Currency Devaluation 💱

There’s also a tricky geopolitical move that can be played when currency has a fair market price. One country might be able to hop into the market and offer to buy another nation’s currency for more USD than it’s currently worth. In doing this, they lower the value of the nation’s currency without raising inflation.

Other countries can then import more goods from that country for the same amount of USD – thus increasing exports while lowering imports. While this might sound like sneakiness that we wouldn’t want to see in the geopolitical realm, we would be tragically optimistic to say it doesn’t happen. This essentially happens all the time. 🕰

Conclusion 🏁

You’ve floated all the way down the river of knowledge to arrive at the pool of success! (That’s probably printed on a poster in someone’s attic somewhere, but we’re not going to go looking for it.)

In all seriousness, floating exchange rates are an important concept to grasp as you use forex trading to take advantage of fluctuations in currencies. Before investing in a particular currency, you want to understand the factors affecting that rate, and of course how likely or unlikely it is to shift in value. After all, most of the major currencies have floating exchange rates – and now you know why, and how it affects them.

So, happy trading! 🚀

Floating Exchange Rate: FAQs

  • What is an Example of a Floating Exchange Rate?

    A floating exchange rate refers to currencies whose relative values change without restriction from their governments. The United States Dollar and the Euro both have floating exchange rates, meaning their relative values today will be different from their relative values tomorrow.

  • Does the United States Have a Floating Exchange Rate?

    Yes, the United States has a floating exchange rate.

  • How Does a Managed Floating Exchange Rate Work?

    A managed floating exchange rate refers to a setup where a nation’s currency exchange rate is neither completely free nor completely fixed, but instead kept within a certain range against another currency or set of currencies. 

Get Started with a Forex Broker

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Demo account?
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Rating
Fees
Minimum initial deposit

$100

$0

All-in cost EUR/USD - active

0.7

N/A

Average spread EUR/USD standard

1

N/A

General
Total currency pairs

82 (in US)

105

Demo account?
Social / copy trading?
Rating
Fees

Minimum initial deposit

$50

$100

$0

All-in cost EUR/USD - active

N/A

0.7

N/A

Average spread EUR/USD standard

0.75

1

N/A

General

Total currency pairs

47

82 (in US)

105

Demo account?

Social / copy trading?

All reviews, research, news and assessments of any kind on The Tokenist are compiled using a strict editorial review process by our editorial team. Neither our writers nor our editors receive direct compensation of any kind to publish information on tokenist.com. Our company, Tokenist Media LLC, is community supported and may receive a small commission when you purchase products or services through links on our website. Click here for a full list of our partners and an in-depth explanation on how we get paid.

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