Floating exchange rates
Countries can choose the exchange rate system they operate with – the main options are:
(1) Free-floating exchange rate
(2) Managed floating system
(3) Semi-fixed exchange rate system
(4) Fully-fixed exchange rate system
(5) Monetary Union with other countries
Since 1992 the UK has operated with a floating exchange rate – the external value of the currency has been left
to market forces i.e. the supply and demand for sterling in the global foreign exchange markets. In a pure
floating system, there is official target for the exchange rate and there is no need for intervention in the currency
market by the central bank.
The economic arguments for a
floating exchange rate
United Kingdom Effective Exchange Rate Index
Index
Trade-weighted index value for sterling in the foreign exchange market, daily value
110
110
105
105
100
100
95
95
90
90
85
85
80
80
90
91
92
93
94
95
96
97
98
99
00
01
02
03
04
05
06
07
08
1. Less need to hold huge
foreign currency reserves
for use in FX market
intervention
2. Floating currencies can be
a useful instrument of
macroeconomic adjustment
e.g. a lower currency can
stimulate aggregate
demand (a good example at
the moment is the
depreciation of sterling v
the Euro)
3. Provides partial “automatic
correction” for a trade deficit e.g. a wide trade deficit should lead (cet par) to an excess supply of sterling
leading to a lower currency (but beware of the possible ‘J curve effect’!)
4. Reduced risk of currency speculation – speculators often target fixed exchange rates that they feel are
over or under-valued
5. Freedom (autonomy) for domestic monetary policy - allows countries greater freedom to set interest
rates for domestic economic aims such as inflation control / maintaining economic growth
6. Floating exchange rates don’t always have to be volatile – consider the chart above which shows the
sterling trade-weighted index – which was remarkably stable from 1997 to 2006.
Risks with floating exchange rates
1. Danger that the currency is volatile which may harm international trade and capital investment – one of
the arguments either for s semi-fixed system or perhaps joining a currency union
2. Fluctuating currencies increases the need for hedging costs by exporters and importers
3. Fixed exchange rate provides a discipline on domestic producers to keep costs & prices down – may be
less significant if the currency moves up and down – if businesses know that the currency might fall to
provide them with a competitive boost, they might be less likely to pursue productivity gains.
UK Trade and the Exchange Rate
0.0
-0.5
-1.0
-1.0
-1.5
-1.5
-2.0
-2.0
-2.5
-2.5
-3.0
-3.0
-3.5
-3.5
-4.0
Effective ex rate index (millions)
-4.5
billions
0.0
-0.5
-4.0
-4.5
UK Trade Balance £bn
-5.0
-5.0
106
106
104
104
102
102
100
100
98
98
96
96
94
millions
GBP (billions)
Monthly balance of trade in goods and services (seasonally adjusted) and exchange rate index
94
00
01
02
03
04
05
06
07
08
Source: Reuters EcoWin
United States Balance of Trade in Goods
130
125
125
120
120
115
115
110
110
105
105
100
100
95
95
0
0
-10
-10
-20
-20
-30
-30
-40
-40
-50
-50
-60
-60
-70
billions
USD (billions)
Index
$ billion per month
130
-70
00
01
02
03
04
05
06
07
08
Federal Reserve, Trade Weighted Exchange Index Broad
Trade Balance, Total, Goods and services, SA
Source: Reuters EcoWin
The key argument
Countries have always faced constraints in choosing their exchange rate regime.
Any country can have only two out of the following three:
1. An independent monetary policy (freedom to set interest rates)
2. A fixed exchange rate (currency stability and predictability)
3. An open capital account (freedom to finance a current account deficit)
As international financial markets have developed, there has been a general movement to flexible
exchange rates supported by credible domestic monetary policies. That is a sensible use of the price
mechanism to respond to complex and unpredictable shocks.
The floating exchange rate system has suited the UK well – we are an open economy with a large
current account deficit and need the flexibility that a market determined currency provides