A floating exchange rate occurs when the currency of country is set by the foreign exchange market through the supply and demand for that particular currency relative to other currencies. Thus, it can be said that floating exchange rates change freely and are determined by trading in the foreign exchange market. In some instances, if the value of a currency moves in any one direction at a rapid and sustained rate, central banks intervene through buying and selling its own currency reserves in the foreign exchange market so as to stabilize the local currency.
Over the past years, many countries have pursued inflation targets as the primary goal of monetary policy. By targeting inflation, they are giving less importance to the exchange rate, thus, the exchange rate floats freely.
At times, it occurs that countries are not in an official exchange rate mechanism, but still do pay attention to the value of the exchange rate. Though they have no published target for the exchange rate, they may intervene under certain circumstances. For instance, if the exchange rate deteriorated rapidly, they may push upwards, interest rates to keep the strength of the value.
In the modern world, most currencies are described as floating. In fact, such currencies include those that are widely traded like the United States dollar, the Euro, the Norwegian Krone, the British Pound, Japanese Yen, Australian dollar and the Swiss Franc. However, central banks often try to take part in the trading activities in the market with the aim of influencing the value of floating exchange rates. The only currency that can be described as purely floating is the Canadian Dollar because; the central bank has not tried to interfere with its price since it stopped the act in 1998.
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The US dollar closely follows the Canadian dollar among those currencies that resemble pure floating currencies. However, there are usually some little changes to the foreign reserves of the US dollar. The UK and Japan central banks always intervene to greater extent when it comes to the prices of their currencies.
According to what most economists think, floating exchange rates are preferable to fixed exchange rates. However, it should be noted that exchange rate adjust automatically, enabling a country to dampen the effects of foreign business cycles and shocks, and to pre-empt the possibility of having a crisis of a balance of payments. In some situations, fixed exchange rates may be preferable since they are certain and possess greater stability.
A floating exchange rate allows monetary policies to be useful for other purposes. Under fixed rates, monetary policy is committed to the single goal of maintenance of exchange rate at its announced level. A system of floating exchange rates leaves monetary policy makers with the freedom of pursuing other options like stabilizing prices or employment. It is important to note that a free floating exchange rate increases the volatility of foreign exchange. Some economists are of the opinion that this could lead to serious problems, especially in emerging economies.
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