Floating Exchange Rate

Almost every sovereign nation in the world issues and controls its own currency. There are some countries which have elected to use another country's currency, primarily the United States Dollar. Sovereign currencies are the legal tender within their respective countries. The need for exchange rates between sovereign currencies has arisen as international trade has spread and flourished.

The exchange rate describes how much of one currency must be given up in order to secure a unit of another currency, for example, if you surrender one British Pound, you will receive approximately one United States Dollar and sixty cents. The exchange rate is said to be 1:1.60.

When a currency is said to have a floating exchange rate, this means that the ratio of exchange for the currency against other currencies is determined by the forces of supply and demand on the foreign exchange markets. The exchange rate is influenced by a variety of factors such as the stability of the country, its balance of payments situation and its rate of inflation relative to the inflation rates experienced by its major trading partners.

Many leading economists are of the opinion that floating exchange rate regimes are superior to fixed exchange rate regimes. Floating exchange rates allow a currency to automatically adjust to international events and allow the currency to dampen the impact of economic shocks and the effects of the international business cycles. The floating of a currency should also assist governments to avoid any balance of payments crises, such as those which triggered the Asian financial crisis of the 1990’s.

Though a currency may generally be said to be floating, in cases of extreme appreciation or depreciation, the government may intervene to stabilize the currency through its Central Bank. This intervention will comprise of selling or buying the nation’s currency. This is technically known as a Managed Float and this policy is frequently used by the Japanese government.

The Mundell-Fleming Model sets out the debate between fixed and floating exchange rate policies and it argues that an economy cannot simultaneously maintain a fixed exchange rate, free movement of capital and an independent monetary policy. It can use any two of the three factors to control the economy but must leave the third factor to the markets.

Floating Exchange Rate and Gold

In 1971, President Nixon closed the gold window, abolishing the direct convertibility of the United States dollar into gold and finally ending the Bretton Woods system and the gold standard. That move known as the "Nixon shock" resulted in the free-floating of fiat currencies (although some developing countries fixed their currencies to U.S. dollar or other major currencies). This is why the price of gold surged in the 1970s – investors worried about the stability of the new monetary system based on freely fluctuating exchange rates between fiat currencies. Although this system showed some resilience over the years, it remains fragile, as the Great Recession showed. Hence, gold serves as an insurance against the current monetary system based on the fiat, freely floating U.S. dollar. The reasons behind the safe-haven properties of gold are simple: our monetary system based on the free-floating exchange rates between fiat currencies has been here only since 1971, while gold used to be money for thousands of years. Therefore, when this faith decreases, especially in the U.S. dollar, the unofficial world currency, gold prices rise.

We encourage you to learn more about the gold market – not only about the link between the floating exchange rates and the yellow metal, but also how to successfully use gold as an investment and how to profitably trade it. A great way to start is to sign up for our gold newsletter today. It's free and if you don't like it, you can easily unsubscribe.