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Floating Exchange Rate - Indian Economy Notes

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Sunil Kumar D Mar 22, 2023

When the market's supply and demand of currencies are used to determine the exchange rate, it is known as a
floating exchange rate. In this exchange rate regime, the Central Bank (RBI) or government can indirectly
influence the exchange rate by managing the level and volume of foreign and domestic currencies in the banking
system. In this article, we will discuss the floating exchange rate that is important for the UPSC examination.

Table of Contents

1. Floating Exchange Rate

2. Background
3. Mechanism
4. Regime - Working
5. Currency Speculation
6. Interest rates and Exchange rates
7. Advantages
8. Disadvantages
9. Difference between Fixed Exchange Rate and Floating Exchange Rate
10. Conclusion
11. FAQs
12. MCQs

What is a Floating Exchange Rate?

A floating exchange rate is a system in which the forex market determines the value of a country's currency
based on supply and demand in relation to other currencies.
This is in contrast to a fixed exchange rate, which is set fully or primarily by the government. It uses no pre-
determined exchange rate target of the government or the Central Bank.
In a floating exchange rate system, depreciation is when there is a rise in the exchange rate of the domestic
currency vis-à-vis another foreign currency. This means that a greater amount of money is required to buy one
unit of foreign currency.
Appreciation is when there is a fall in the exchange rate of the domestic currency vis-à-vis another foreign
currency

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 Fixed Exchange Rate Managed floating exchange rate

Nominal Exchange Rate Nominal Effective Exchange Rate

Real Exchange Rate Real Effective Exchange Rate

Floating Exchange Rate - Background

In July 1944, the Bretton Woods Conference took place, which created a gold standard for currencies. A total
of 44 countries were represented, with attendance limited to World War II Allies.
The International Monetary Fund (IMF) and the World Bank were founded at the Conference, as well as
rules for a fixed exchange rate regime.
With member countries pegging their currencies to the dollar, the scheme established a gold price of $35 per
ounce. It was possible to make adjustments of up to 1%. The dollar became the reserve currency, allowing
central banks to intervene in interest rates to alter or stabilize them.
India switched to a managed floating exchange rate in 1994.

Mechanism Behind Floating Exchange Rate

It tells about long-term currency price changes that reflect economic strength and interest rate differentials
between countries.
A floating exchange rate currency during short-term moves is reflective of rumors, speculation, etc.
If supply increases over demand then the currency value will fall, and if demand increases oversupply then the
currency value will rise.
Intervention by central banks can happen in case of extreme short-term moves, because of this although
most major global currencies are floating, central banks can step in if a nation's currency becomes too high or
too low.
This happens as a fluctuating currency can impact a nation's economy negatively, affecting its trade, ability to
pay debts, etc.

Floating Exchange Rate Regime - Working

Depreciation of domestic currency

The image below indicates the relation between the exchange rate and the quantity of foreign currencies. Here as
a result of market forces the demand for foreign currency increases and the demand curve moves from D1 to
D2. As a result, the local currency depreciates. Hence, the exchange rate increases

(Floating Exchange Rate)

Appreciation of domestic currency
The image below indicates the relation between the exchange rate and the number of foreign currencies. Here as
a result of market forces the supply of foreign currency increases and the supply curve moves from S1 to S2.
This puts downward pressure on the market value of the exchange rate and the exchange rate decreases. Hence,
the local currency appreciates

Currency Speculation
Currency speculation is the act of buying and holding the foreign currency with the intention of selling it at a
higher rate in the future.
Those who buy currencies to finance a foreign venture or pay for an import, on the other hand, are doing it for
a different reason.
Currency trading is a little different from currency speculating. Both, in some way or another, make foreign
transactions easier. Nothing prevents a trader from also behaving as a speculator or a speculator from also
functioning as a trader.
A trader will buy foreign currency from importers/exporters and charge a transaction fee, but there is nothing
preventing them from keeping the currency in the hope of selling it at a higher price in the future (and thereby
engaging in speculation).
This can lead to the change in exchange rates due to speculations in the short term due to buying and
selling of foreign currencies.

Interest rates and Exchange rates

Interest rates, inflation, and currency exchange rates are all closely linked. Central banks control both
inflation and exchange rates by controlling interest rates, and changing interest rates affects both inflation and
currency values.
Higher interest rates provide a better return to lenders in a given country when compared to other countries.
As a result, higher interest rates attract foreign capital, driving up the currency rate.
However, the impact of increased interest rates is lessened if inflation in the country is substantially higher
than in others, or if other factors contribute to the currency's depreciation.
Lower interest rates have the inverse relationship, i.e., lower interest rates tend to lower exchange rates.

Advantages of Floating Exchange Rate Regime

It provides stabilization as disequilibrium in the balance of pay­ments is automatically corrected by a change
in the exchange rate.
The floating exchange rate system helps in rectifying the balance of payments deficit of a country by changing
the external price of the currency.
The possibility of an international monetary crisis originating from ex­change rate changes is automatically
eliminated in the case of a floating exchange rate regime.
National governments enjoy discretion and hence are free to manipulate the external value of their currency
to their own advantage.
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It prevents importing of inflation as could happen in a fixed exchange rate regime.
Disadvantages of Floating Exchange Rate Regime
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There is a greater degree of instability as currencies change in value from day today.
It may discourage foreign direct investment (i.e., investment by multinational companies).
Increased fluctuations may lead to speculative movements of ‘hot money from country to country, resulting in
more exchange rate fluctuations.
In a floating exchange rate, short-run problems such as domestic inflation may be ig­nored until they have
created crisis situations.

Difference between Fixed Exchange Rate and Floating Exchange Rate

Fixed Exchange Rate Floating Exchange Rate

The foreign exchange markets are completely manipulated The market is free to determine the value of
by the government under this regime. the exchange rate under this arrangement.

The official exchange rate is set by the government or central

The forces of demand and supply determine
bank and is linked to the price of gold or major currencies
the exchange rate.
such as the US dollar.

If the exchange rate swings for whatever

If the exchange rate changes for any reason, the government
reason, the government never intervenes and
intervenes to ensure that the pre-determined equilibrium
instead lets the market determine the genuine
level is maintained.
worth of the currency.

The only advantage of a fixed exchange rate regime is that it The only disadvantage of a floating exchange
ensures exchange rate stability. It guards against both rate system is that the exchange rate varies
appreciation and depreciation of the currency. greatly from day to day.

The following are some of the benefits of such

The following are some of the numerous downsides of such
a system:
a system:
the currency rate is established by well-
It places a significant responsibility on governments to
functioning foreign exchange markets with
maintain exchange rates. This is especially true during
no government intervention.
times of deficits when governments must inject a large
The exchange rate represents the genuine
amount of money to keep the exchange rate stable.
worth of the home currency, which aids in
Foreign investors avoid investing in such countries
the development of foreign investor
because they believe the exchange rate does not reflect
confidence.
the genuine value of the economy, and they are afraid of
A country can readily obtain funds/loans
losing their money.
from the IMF and other institutions.
 Economics: Floating Exchange Rates

Conclusion
A floating exchange rate regime involves a system in which the currency price of a nation is set by the forex
market based on supply and demand relative to other currencies. It stabilizes the balance of payment crisis,
prevents the import of inflation. However, appropriate measures should be taken while resorting to this exchange
system as it may lead to instability and discourage foreign investments from impacting the economic growth of a
nation.

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Indian Economy Notes Indian Forex Reserves

Indian Foreign Exchange Market Forex Related Terms

FAQs

Question: What is the advantage of a floating exchange rate? ➕

Question: What are some of the countries with a floating exchange rate regime? ➕
Question: How does a floating exchange rate regime work? ➕
MCQs
Question: Foreign currency which has a tendency for quick migration called?

(a) Hot currency

(b) Soft currency

(c) Gold currency

(d) Scarce currency

Answer: (a) See The Explanation ➕

Question: Consider the following actions that the government can take:

1. Devaluing the domestic currency.

2. Reduction in the export subsidy.
3. Adopting suitable policies which attract greater FDI and more funds from FIIs.

Which of the above action/actions can help in reducing the current account deficit?

(a) 1 and 2

(b) 2 and 3

(c) 3 only

(d) 1 and 3

Answer: (d) See The Explanation ➕

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