how a floating exchange rate works
floating exchange rate systems mean long term currency price changes reflect relative economic strength and interest rate differentials between countries short term moves in a floating exchange rate currency reflect speculation rumors disasters and everyday supply and demand for the currency if supply outstrips demand that currency will fall and if demand outstrips supply that currency will rise extreme short term moves can result in intervention by central banks even in a floating rate environment because of this while most major global currencies are considered floating central banks and governments may step in if a nation s currency becomes too high or too low a currency that is too high or too low could affect the nation s economy negatively affecting trade and the ability to pay debts the government or central bank will attempt to implement measures to move their currency to a more favorable price floating vs fixed exchange ratescurrency prices can be determined in two ways a floating rate or a fixed rate as mentioned above the floating rate is usually determined by the open market through supply and demand therefore if the demand for the currency is high the value will increase if demand is low this will drive that currency price lower a fixed or pegged rate is determined by the government through its central bank the rate is set against another major world currency such as the u s dollar euro or yen to maintain its exchange rate the government will buy and sell its own currency against the currency to which it is pegged some countries that choose to peg their currencies to the u s dollar include china and saudi arabia the currencies of most of the world s major economies were allowed to float freely following the collapse of the bretton woods system between 1968 and 1973 1history of floating exchange rates via the bretton woods agreementthe bretton woods conference which established a gold standard for currencies took place in july 1944 a total of 44 countries met with attendees limited to the allies in world war ii the conference established the international monetary fund imf and the world bank and it set out guidelines for a fixed exchange rate system 2the system established a gold price of 35 per ounce with participating countries pegging their currency to the dollar adjustments of plus or minus 1 were permitted the u s dollar became the reserve currency through which central banks carried out intervention to adjust or stabilize rates 3the first large crack in the system appeared in 1967 with a run on gold and an attack on the british pound that led to a 14 3 devaluation president richard nixon took the united states off the gold standard in 1971 45by late 1973 the system had collapsed and participating currencies were allowed to float freely 1failed attempt to intervene in a currencyin floating exchange rate systems central banks buy or sell their local currencies to adjust the exchange rate this can be aimed at stabilizing a volatile market or achieving a major change in the rate groups of central banks such as those of the g 7 nations canada france germany italy japan the united kingdom and the united states often work together in coordinated interventions to increase the impact an intervention is often short term and does not always succeed a prominent example of a failed intervention took place in 1992 when financier george soros spearheaded an attack on the british pound the currency entered the european exchange rate mechanism erm in oct 1990 the erm was designed to limit currency volatility as a lead in to the euro which was still in the planning stages 6soros believed that the pound had entered at an excessively high rate and he mounted a concerted attack on the currency the bank of england was forced to devalue the currency and withdraw from the erm the failed intervention cost the u k treasury a reported 3 3 billion soros on the other hand made over 1 billion 7central banks can also intervene indirectly in the currency markets by raising or lowering interest rates to impact the flow of investors funds into the country since attempts to control prices within tight bands have historically failed many nations opt to free float their currency and then use economic tools to help nudge it in one direction or the other if it moves too far for their comfort 