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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.
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 "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 (read: government) cannot simultaneously maintain a fixed exchange rate, free capital movement, and an independent monetary policy. It can choose any two for control, and leave the third to 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.
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A floating currency is a currency that uses a floating exchange rate as its exchange rate regime. A floating currency is contrasted with a fixed currency.
In the modern world, the majority of the world's currencies are floating. Central banks often participate in the markets to attempt to influence exchange rates. Such currencies include the most widely traded currencies: the United States dollar, the euro, the Norwegian krone, the Japanese yen, the British pound, the Swiss franc[1] and the Australian dollar. The Canadian dollar[2] most closely resembles the ideal floating currency as the Canadian central bank has not interfered with its price since it officially stopped doing so in 1998. The US dollar[3] runs a close second with very little changes in its foreign reserves; by contrast, Japan[4] and the UK[5] intervene to a greater extent. From 1946 to the early 1970s, the Bretton Woods system made fixed currencies the norm; however, in 1971, the United States government abandoned the gold standard, so that the US dollar was no longer a fixed currency, and most of the world's currencies followed suit.
A floating currency is one where targets other than the exchange rate itself are used to administer monetary policy. See open market operations.
A free floating exchange rate increases foreign exchange volatility. There are economists who think that this could cause serious problems, especially in emerging economies. These economies have a financial sector with one or more of following conditions:
When liabilities are denominated in foreign currencies while assets are in the local currency, unexpected depreciations of the exchange rate deteriorate bank and corporate balance sheets and threaten the stability of the domestic financial system.
For this reason emerging countries appear to face greater fear of floating, as they have much smaller variations of the nominal exchange rate, yet face bigger shocks and interest rate and reserve movements.[6] This is the consequence of frequent free floating countries' reaction to exchange rate movements with monetary policy and/or intervention in the foreign exchange market.
The number of countries that present fear of floating increased significantly during the 1990s.[7]
The primary argument for a floating exchange rate is that it allows monetary policies to be useful for other purposes. Under fixed rates monetary policy is committed to the single goal of maintaining exchange rate at its announced level. yet the exchange rate is only one of many macro economic variable that monetary policy can influence. A system of floating exchange rate leaves monetary policy makers free to pursue other goals such as stabilizing employment or prices.