A floating exchange rate is a system in which the value of a currency is found out by the play of demand and supply in the market. The currency value in such an exchange rate regime is not determined by government interventions. Even so, a vast majority of central banks try to ensure that their currency remains strong. To keep the currency value at an acceptable level the central bank of a country may either buy or sell its currency, depending on the current situation.
Fiat currencies are not necessarily ruled by a fixed exchange rate. As a matter of fact, a fiat currency is well suited to a floating exchange rate regime. In floating exchange rate regime, the currency value of a country is calculated in the foreign exchange market.
A floating exchange rate has both a good side to it and a bad side. Here is a brief look at both. The biggest positive to the floating exchange rate is that it does not require international management. Thus, there is no need for the IMF to deal with imbalances in a country’s current account. This is because whenever countries have a huge current account deficit, the value of their currency immediately goes down accordingly.
Secondly, a floating exchange rate does not require regular interventions by the central bank. Such interventions are only required in a fixed exchange rate regime. Finally, with a floating exchange rate, countries do not need to enforce complicated restrictions on capital flows. That is how their markets work efficiently. Also, with a floating exchange rate there is a higher degree of insulation against economic problems affecting other countries.
The downsides to using a floating exchange rate are many. Here is a brief look at some of them. Floating exchange rate means greater volatility. Also, a floating exchange rate forces countries to make greater use of their scarce resources in order to find out and predict the exchange rate of other currencies. A floating exchange rate also has a tendency to exacerbate any current problems affecting a particular country.
So, if a country experiences certain economic woes like unemployment, the floating exchange rate end up worsening the unemployment situation.
