24 Floating rates
Overview
Following the collapse of the Bretton Woods system in 1973, many economists argued that exchange rates should be allowed to float freely rather than being fixed by central banks.
A floating exchange rate system was expected to:
- restore monetary policy independence;
- eliminate the asymmetries of Bretton Woods;
- allow exchange rates to act as automatic stabilizers;
- help countries maintain external balance automatically.
Although floating rates solved several problems of fixed exchange rates, later experience showed that expectations about their performance were often too optimistic.
Definition
A floating exchange rate system is an international monetary system in which:
- exchange rates are determined by market forces;
- central banks do not intervene systematically to fix exchange rates;
- currency values adjust continuously according to demand and supply in the foreign exchange market.
Historical Context
During the late 1960s and early 1970s, Bretton Woods experienced increasingly frequent balance-of-payments crises and speculative attacks.
In March 1973, most major economies abandoned fixed exchange rates and adopted floating exchange rates.
Many economists welcomed this transition because they believed markets could determine exchange rates more efficiently than governments.
How it Works
1. Market-determined exchange rates
Under floating rates:
- no official parity exists;
- exchange rates adjust continuously;
- central banks are no longer required to defend a fixed exchange rate.
Exchange rates move in response to:
- monetary policy;
- interest rates;
- inflation;
- expectations;
- capital flows;
- trade flows.
2. Monetary Policy Autonomy
The main advantage of floating exchange rates is monetary independence.
Central banks can:
- expand the money supply during recessions;
- contract the money supply during inflationary periods;
without worrying about defending a fixed exchange rate.
Floating exchange rates therefore resolve the Monetary Trilemma by choosing:
- independent monetary policy;
- free capital mobility;
while sacrificing fixed exchange rates.
3. Protection from Foreign Inflation
Floating exchange rates insulate countries from foreign inflation.
Suppose foreign prices increase because of excessive monetary expansion.
Purchasing Power Parity predicts that, in the long run,
\[\%\Delta E \approx \pi_{foreign}-\pi_{home}\]
The foreign currency depreciates while the domestic currency appreciates.
As a result, imported inflation is largely offset by exchange-rate movements.
4. Symmetry
Under Bretton Woods, the United States occupied a privileged position because the dollar served as the world's reserve currency.
Under floating exchange rates:
- no country controls the international monetary system;
- every country has equal freedom to conduct monetary policy;
- exchange rates adjust symmetrically through market forces.
5. Exchange Rates as Automatic Stabilizers
Floating exchange rates help absorb economic shocks automatically.
Example:
Suppose foreign demand for domestic exports falls.
Under floating rates:
- exports decline;
- aggregate demand falls;
- domestic interest rates decrease;
- the currency depreciates;
- exports become more competitive;
- part of the initial shock is offset.
Currency depreciation cushions the fall in output and employment.
Under fixed exchange rates, by contrast, the central bank must contract the money supply to defend the exchange rate, making the recession deeper.
6. External Balance
Floating rates were also expected to prevent persistent current-account imbalances.
If a country develops a large current-account deficit:
- markets anticipate future depreciation;
- speculators sell the currency;
- depreciation makes exports cheaper;
- imports become more expensive;
- the current account gradually improves.
The same mechanism works in reverse for large current-account surpluses.
Economic Intuition
Floating exchange rates act as an automatic adjustment mechanism.
Instead of forcing governments to change interest rates or reduce domestic demand, exchange-rate movements absorb part of external shocks.
Consequently:
- external balance adjusts more smoothly;
- output fluctuates less;
- speculative crises associated with fixed exchange rates become less likely.
Advantages
- Independent monetary policy.
- Greater capital mobility.
- Automatic exchange-rate adjustment.
- Better insulation from foreign inflation.
- Exchange rates absorb external shocks.
- Less need for exchange-rate realignments.
- Reduced risk of balance-of-payments crises caused by fixed parities.
- Greater symmetry among countries.
Disadvantages
- Exchange rates may become highly volatile.
- Exchange-rate uncertainty can affect trade and investment.
- Markets may overshoot equilibrium values.
- Speculation can amplify exchange-rate movements.
- Persistent current-account imbalances may still occur.
- Floating does not eliminate international policy conflicts.
Connections
- Floating Exchange Rates
- Bretton Woods System
- Monetary Trilemma
- Purchasing Power Parity (PPP)
- Automatic Stabilizers
- External Balance
- Current Account
- Capital Mobility
- Monetary Policy
- Exchange Rate Overshooting
- Balance-of-Payments Crisis
- Speculation
Questions
- Why did economists support floating exchange rates after 1973?
- How do floating rates resolve the Monetary Trilemma?
- Why do floating rates increase monetary policy autonomy?
- How does PPP explain insulation from foreign inflation?
- Why are floating rates considered automatic stabilizers?
- How does currency depreciation reduce the impact of an export shock?
- Why were floating rates expected to improve external balance?
- Why can floating exchange rates still be volatile?
Common Misconceptions
"Floating exchange rates eliminate economic crises."
False.
They reduce some types of crises (such as speculative attacks on fixed parities) but exchange-rate volatility and financial crises may still occur.
"Floating exchange rates mean central banks never intervene."
Not necessarily.
Although exchange rates are market determined, central banks may occasionally intervene to reduce excessive volatility.
"Floating exchange rates always stabilize the economy."
Not always.
They often cushion external shocks, but exchange-rate movements themselves can sometimes become a source of instability.
Key Takeaways
- Floating exchange rates were adopted after the collapse of Bretton Woods in 1973.
- Exchange rates are determined by market forces.
- Floating restores monetary policy independence.
- PPP helps explain insulation from foreign inflation.
- Exchange-rate movements automatically absorb external shocks.
- Floating rates increase symmetry among countries.
- Economists initially expected floating rates to reduce current-account imbalances and speculative crises.
- Later experience showed that floating exchange rates are more volatile than many economists originally expected.