A floating
exchange rate or fluctuating exchange rate is a type of exchange-rate regime in which a currency's
value is allowed to fluctuate in response to market mechanisms of the foreign-exchange market. A currency that
uses a floating exchange rate is known as a floating currency. A floating
currency is contrasted with a fixed
currency.In a fixed exchange rate system, the government (or the
central bank acting on the government's behalf) intervenes in the currency
market so that the exchange rate stays close to an exchange rate target. When
Britain joined the European Exchange Rate Mechanism in October 1990, we fixed
sterling against other European currencies. The pound, for example, was
permitted to vary against the German Mark by only 6% either side of a central
target of DM2.95. Britain left the ERM in September 1992 when the pound came under
sustained selling pressure, and the authorities could no longer justify very
high interest rates to maintain the pound's value when the domestic economy was
already suffering from a deep recession.
Fluctuations in the exchange rate can provide an automatic adjustment for countries
with a large balance of payments deficit. If an economy has a large deficit,
there is a net outflow of currency from the country. This puts downward
pressure on the exchange rate and if a depreciation occurs, the relative price
of exports in overseas markets falls (making exports more competitive) whilst
the relative price of imports in the home markets goes up (making imports
appear more expensive).
This should help reduce the
overall deficit in the balance of trade provided that the price elasticity of
demand for exports and the price elasticity of demand for imports is
sufficiently high. A second key advantage of floating exchange rates is that it
gives the government / monetary authorities flexibility in determining interest rates. This is because
interest rates do not have to be set to keep the value of the exchange rate
within pre-determined bands. For example when the