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Advanced explained: Free Floating Exchange Rate
Source: | Author:finance-102 | Date2023-03-01 | 352 Views | Share:
A free floating exchange rate, also known as a flexible exchange rate, is a type of exchange rate regime in which the value of a currency is determined by the forces of supply and demand in the foreign exchange market, without any intervention by the government or central bank. Under a free floating exchange rate system, the exchange rate is allowed to fluctuate freely in response to market conditions, such as changes in economic indicators, international trade, and capital flows. This means that the exchange rate can appreciate or depreciate in value depending on the market's perception of the currency's worth.

A free floating exchange rate, also known as a flexible exchange rate, is a type of exchange rate regime in which the value of a currency is determined by the forces of supply and demand in the foreign exchange market, without any intervention by the government or central bank. Under a free floating exchange rate system, the exchange rate is allowed to fluctuate freely in response to market conditions, such as changes in economic indicators, international trade, and capital flows. This means that the exchange rate can appreciate or depreciate in value depending on the market's perception of the currency's worth.


Free floating exchange rate regimes are often preferred by countries that prioritize flexibility and independence in their monetary policy, as they allow the central bank to focus on domestic economic conditions rather than external pressures. However, they can also be more volatile and subject to greater fluctuations than fixed or managed exchange rate regimes.


There are several advantages associated with a free floating exchange rate regime, including:


  • Market Efficiency: A free floating exchange rate allows market forces to determine the value of a currency, which reflects the underlying economic fundamentals such as trade, investment, and inflation. This makes the foreign exchange market more efficient, as prices adjust to new information in a timely manner.

  • Monetary Independence: With a free floating exchange rate regime, central banks have more independence in their monetary policy decisions. They can adjust interest rates and implement other policies without having to worry about maintaining a fixed exchange rate or defending the value of the currency.

  • External Shock Absorption: A free floating exchange rate regime can help a country absorb external economic shocks, such as changes in global oil prices, natural disasters, or financial crises. With a flexible exchange rate, the currency can adjust quickly to changes in the global economy, which can help stabilize the domestic economy.

  • Trade Competitiveness: A free floating exchange rate can help make a country's exports more competitive in global markets, as the currency can depreciate in value to reflect changes in trade flows or changes in relative productivity. This can lead to increased exports and economic growth.

  • Reduced Speculation: With a free floating exchange rate, there is less incentive for speculators to bet against the currency or engage in currency speculation, as there are no fixed exchange rates to challenge. This can help reduce currency volatility and promote stability in the foreign exchange market.


There are several potential disadvantages associated with a free floating exchange rate regime, including:


  • Exchange Rate Volatility: A free floating exchange rate regime can be more volatile than fixed or managed exchange rate regimes, as the exchange rate is subject to the fluctuations of the foreign exchange market. This volatility can make it difficult for businesses and investors to plan and make investment decisions.

  • Economic Uncertainty: The volatility of a free floating exchange rate can also create uncertainty for businesses and investors, which can negatively impact economic growth and investment.

  • Inflationary Pressures: A free floating exchange rate regime can also create inflationary pressures, as a weaker currency can lead to higher prices for imports and inflationary pressures. Central banks may need to use monetary policy tools such as interest rate increases to combat inflation.

  • Speculative Attacks: A free floating exchange rate regime can also be vulnerable to speculative attacks, as speculators may bet against the currency in order to profit from potential future exchange rate fluctuations. This can lead to further exchange rate volatility and economic instability.


Overall, a free floating exchange rate regime offers greater flexibility, independence, and market efficiency compared to fixed or managed exchange rate regimes. However, it also requires a stable macroeconomic environment, a well-functioning financial system, and effective monetary policy to manage volatility and maintain economic stability.